For many, retirement savings in a 401(k) or IRA may be their biggest financial asset. Here is a summary of retirement account basics and how they may be divided in the event of divorce.
Retirement Account Basics
In a nutshell, retirement accounts are tax-advantaged vehicles designed to be withdrawn in retirement, or after age 59 ½. Many people have retirement savings plans (Employer Retirement Plans) at work as part of their company benefits package, but you can also save for retirement on your own.
There are two broad types of employer retirement plans: Defined Contribution (DC) and Defined Benefit (DB) plans. You may also have heard them referred to as Qualified Plans. They are “Qualified” by ERISA Act of 1974, which set certain rules and protections for these types of accounts.
Defined Contribution plans include 401(k), 403(b), ESOP (Employee Stock Option Plan), and Profit Sharing Plans. It isn’t difficult to determine the cash value of your 401(k); just look at your last statement.
The cash value of the account may not be the whole story, however. Vesting refers to the schedule at which funds are fully owned by the employee. Employee contributions are always 100% vested, but contributions to your retirement account made by your employer may vest over a period of time ranging from 3-7 years. Unvested balances are typically not part of the divorce settlement.
Defined Benefit plans are the more “traditional” pension plan, which guarantees a stream of payments for life, starting at retirement. Although a working employee does not currently receive any pension payments, there is a value to the expected future stream of payments and the company guarantee. This means the pension may be included in the divorce settlement, even if the employee is not yet receiving benefits.
Determining the present value of the future payments can be complex. Use a financial planner who specializes in divorce or a pension consultant.
Personal Retirement Accounts include Traditional IRA, Roth IRA and Annuities. IRA stands for Individual Retirement Arrangement.
What is a QDRO?
QDRO (called “quadro”) stands for Qualified Domestic Relations Order. This is the legal document required to divide up a Qualified Retirement Plan. Division may be equal or unequal – there is no requirement that it be 50/50. The QDRO is a legal document and must be accepted by the company’s retirement Plan Administrator. Your divorce attorney or mediator will not typically draft the QDRO, as there are companies which specialize in writing the agreements, who are familiar with company requirements, and who can do it more efficiently than most attorneys.
Division of the account could result in a separate account for the ex-spouse at the employer, even though he or she is not an employee, or transfer of the appropriate dollar amount to an IRA for the ex-spouse. In the case of a pension, it could be a stream of payments which begin at retirement age of the recipient or actual retirement of the employee.
Division of accounts by QDRO may have a tax benefit. Withdrawals pursuant to a QDRO are not subject to the 10% penalty that would typically be assessed by the IRS on withdrawals made by persons under age 59 1/2.
Withdrawals may still be subject to income tax, but elimination of the penalty may be a significant cost savings.
Division of Retirement Plans
There are three steps in the division of retirement plans: classification, valuation and division.
Are they marital or separate assets? Marital assets are earned (but not necessarily received) during the marriage. Separate assets may have been acquired before the marriage, or by inheritance or gift. Separation has been maintained; they have not been commingled with marital assets. Separate assets are usually not part of the settlement.
For a Defined Contribution (DC) plan, valuation is relatively simple. You’ll need the statement value for a date agreed to by the parties. This could be the date of separation or the end of year. If only a portion was earned during the marriage, there are two methods of calculation which may be used to separate the marital portion: the segregation or coverture method.
Defined Benefit (DB) plans require a pension appraisal, which may be more complex. This may seem a little confusing, but the value of the pension is not the statement value. The pension appraisal will calculate the present value (PV) of the future benefit to be received from the pension. It will take many factors into account, such as date of employment, marriage date, monthly benefit, retirement age, and life expectancy.
The parties may agree to immediate or deferred distribution of the retirement benefits.
In the case of immediate division, which is most common, a QDRO will be used to separate the accounts. Monies may be withdrawn, transferred to another institution, or rolled over (rollover) to another retirement account, usually an IRA.
If the employee of the defined benefit plan is still active (working and not receiving benefits), immediate division could mean offsetting the pension with other assets. For example: he gets the pension and she gets the house. If the employee is already receiving benefits or will begin receiving them soon, the ex-spouse might choose to receive a portion of the benefits.
Deferred division means that the ex-spouse’s share begins when participant retires. This simplifies the calculation, as they will share actual benefits (a 50/50 or 70/30 split, for example). The company retirement plan actually sends checks to the ex-spouse. Parties should consider the date benefits begin, as well as what happens in the event of remarriage or death of one of the parties.
In summary, retirement assets are an important part of a divorce financial settlement. They should be considered carefully before any settlement decisions are made.
Please note, changes in tax laws may occur at any time and could have substantial impact upon each person’s situation. You should discuss tax or legal matters with the appropriate professional.
Please visit PowerOverDivorce to learn more about Divorce Financial Planning Services.
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