Marriage, divorce & money
How to divide 401(k)s, IRAs, and annuities in a Divorce
Many things occupy your mind during a divorce. Understandably, taxes can likely fall to the bottom of the list. But there are critical tax considerations that should be evaluated, particularly when it comes to dividing qualified assets, such as 401(k)s, IRAs and annuities.
Dividing 401(k)s and pensions can seem quite complex because you need to obtain a Qualified Domestic Relations Order (QDRO), which is a court order separate from a divorce decree. A spouse has legal grounds to all or part of a 401(k), and each plan has specific benefit provisions and administrative rules. For example, some plan administrators require you to wait until retirement to officially divide the assets.
Most divorce attorneys would promote reaching an amicable agreement with your spouse. Here are four options to consider:
As for pensions, they are generally considered jointly owned. Most pensions will pay benefits directly to former spouses, and payments can typically be made for the life of the employee or retiree, as well as after death (whether it occurs before or after retirement). The rules relating to the division of pensions are complicated and vary from state to state and retirement system to system.
Dividing IRA assets is generally considered more straightforward, although it is subject to community property state rules that may differ from state to state. If the IRA was opened during the marriage, it is considered a marital asset. If the IRA pre-existed the marriage, contributions made during the marriage with joint funds may be considered marital property. However, inherited IRAs are usually considered separate property, unless commingled with marital assets.
The rules governing splitting IRAs are consistent, whether it’s a traditional, SEP, Simple or Roth IRA. The only notable difference is that because Roth distributions will ultimately be tax-free, the evaluation of value may be impacted, depending upon whether you use pre-tax versus after-tax valuation in your negotiations. Also, dividing IRA assets requires a divorce decree, but a QDRO is not required.
The most efficient way to divide an IRA is to do a trustee-to-trustee transfer, which moves assets from one spouse’s IRA to the other spouse’s account. This can be beneficial because you will avoid the 10% early distribution penalty (if younger than 59½) and taxes.
Annuities typically require complicated calculations and tax implications, but ultimately their division is contingent upon what is negotiated by the involved parties. In fact, “how” to split annuities becomes the more critical piece after the agreed-upon percentages are decided. The biggest issues are tax consequences, penalties and surrender fees, but there are IRS exceptions for divorces, so these concerns may be avoided.
The most common way to divide annuities in a divorce is to start a new contract by withdrawing from the existing annuity and creating two new contracts (or one contract if the annuity is not being divided and is instead being given to one spouse). This method has the least tax implications because the IRS treats these transfers as non-taxable events. Remember though that the new “owner” will pay income tax on distributions.
An alternative method would be to withdraw via a sell or surrender transaction, where one spouse withdraws a portion or all of an annuity and distributes the proceeds. This is an easy calculation, but it may result in reduced benefits, taxes, surrender fees or a new surrender period. If the annuity resides in an IRA, you can exercise a transfer through a direct rollover, which is easy to execute with fewer tax implications.
Of course, state laws impact how different types of assets are split. For example, residing in a community property state, as opposed to a separate property state, adds wrinkles to the process, which is why it is imperative to consult with your financial and tax advisers.
Navigating a divorce is not easy. When it comes to dividing qualified assets, it’s worthwhile to approach it methodically. The good news is there are experts who help you develop a thoughtful and resilient plan that protects you and your assets.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.