Going through a divorce can be one of the most difficult experiences you’ll ever experience. But it doesn’t have to ruin your financial future. There are certain steps you can take to protect your nest egg during divorce proceedings, and we’ll cover each one. A financial advisor can also serve as a valuable asset as you split property and financials in a divorce. So let’s start by examining how 401(k) assets are split from a legal standpoint in a divorce.
How is a 401(k) Split in a Divorce?
This depends largely on laws in the state where the divorce is finalized. Some states follow “community property” standards. This means your 401(k) is seen as joint property that both you and your spouse own. In such a case, the court generally splits contributions to the plan equally among both spouses.
Most states, however, follow “equitable distribution” rules. This basically means the judge splits the 401(k) assets as he or she deems fair. This doesn’t always mean an even 50/50 split. First, the judge distinguishes between “marital property” and “separate property.” When it comes to 401(k) plans, contributions each spouses made to a 401(k) plan after they got married cover the “marital portion.”
The judge then proceeds with how to divvy up the “marital” portion. The court considers several factors including the financial situation of both spouses, the account balance and length of the marriage.
Nonetheless, you don’t need a court to make this decision. You and your spouse can negotiate and decide on your own how to split up a 401(k) in a divorce. Just make sure you both clearly explain the decision in your “marital settlement agreement” or “divorce settlement” drafted with the help of the attorneys involved.
Whether a couple or a court decides on how to divide 401(k) assets, the next crucial step would be drafting a Qualified Domestic Relations Order (QDRO). The judge must sign this critical document before sending it to the plan administrator. The admin must then approve it before money can be safely moved out of your 401(k).
This is why before you even begin negotiating the splitting of 401(k) assets or seeking legal assistance, you must learn your plan’s rules.
Know 401(k) Plan Administrator Rules Regarding Divorce
401(k) plan administrators must follow strict guidelines in order to comply with the Employee Retirement Income Security Act (ERISA). Thus, plan administrators follow specific rules regarding treatment of 401(k) assets following a divorce. Some, for example, divide portions by percentages. Others split it in “shares.” In addition, some plans won’t allow your spouse to take distributions from the plan until you retire.
So it’s important you review your plan rules and share them with any attorney, CPA or financial advisor you’re working with during the divorce proceedings.
What Do You Need to Divide a 401(k) in a Divorce?
As soon as a court finalizes your divorce, the judge must sign and submit a carefully drawn QDRO to your plan administrator. Once your plan administrator approves the QDRO, you can safely move your ex’s share without facing an early withdrawal penalty if you’re younger than age 59.5.
When assets are getting divided up, the IRS doesn’t see the transaction as a withdrawal as long as it’s done under the direction of a QDRO approved by a plan administrator. QDROs can be complex, so make sure you hire an attorney who specializes in this field. A qualified financial advisor can also serve as a valuable resource if you’re negotiating with a spouse on how to split assets without the overarching guidance of the court.
Once an approved QDRO lays out how to divide 401(k) assets, your ex spouse will have a few options as to how he or she gets her share.
Direct or Indirect Rollover to an IRA
Your ex spouse can initiate a direct rollover of her proper share of your 401(k) into a personal IRA. The transfer itself won’t trigger any taxes on your part or that of your ex. But if your ex makes a withdrawal before reaching age 59.5, he or she would generally owe a 10% early withdrawal penalty in addition to regular income tax.
Keep in mind, however, that these rules apply to direct rollovers. This means a direct plan-to-plan rollover. So, your ex may want to open an IRA before the plan administrator approves the QDRO. One can easily open an IRA at most banks and investment firms.
With an indirect rollover, however, the plan administrator sends a check to your ex in the amount of his or her proper share. Your ex then generally has 60 days to deposit the funds in another plan without facing some serious tax penalties.
If the approved QDRO permits it, the IRS allows your ex to take a lump-sum distribution without facing the 10% tax penalty even if he or she is younger than age 59.5. But because the plan was funded with pre-tax dollars, your ex would still owe the appropriate federal income tax on distributions.
Defer Payments Until Account Owner Retires
If your plan administrator allows it, your ex can leave his or her share invested in the plan and wait until you retire to begin taking distributions. This might make sense if your ex is younger than 59.5 and doesn’t immediately need the funds. However, he or she would need to start taking required minimum distributions (RMD) upon reaching age 70.5.
Divorce is never easy, and one of the most important part of your assets is your retirement nest egg. The process would depend largely on state law, your financial situation and the ever-important QDRO document. However, you can always seek a financial advisor and an attorney to help you and your spouse negotiate a fair way to split up all marital assets without the pressure of the courts. But if it’s up to the court, your ex would most likely roll over the right share into another plan, cash out or leave the money in the plan. Tax implications and specific plan administrator rules will apply, so it’s important to know these. A CPA and financial consultant can help.
Tips on Avoiding Costly Mistakes in a Divorce
- The average cost of a divorce can climb quite high depending on several factors. You need to watch out for some potential pitfalls. One of the best ways to avoid these is by hiring a qualified financial advisor. If you’ve never worked with one, you can find one using our SmartAsset financial advisor matching tool. After answering a few simple questions, it connects you with up to three advisors in your area. You can review their experience and qualifications before deciding which one to work with.
- A divorce may involve some tax implications you won’t expect. To help, we published a guide on filing taxes after divorce.
Photo credit: ©iStock.com/svetikd, ©iStock.com/PrathanChorruangsak, ©iStock.com/BrianAJackson