What happens to retirement funds and 401(k) plans in a divorce?
A divorce is a complicated matter, particularly because it requires dividing up a lifetime partnership in a relatively quick hearing. For this reason, it can become easy to lose sight of some important matters, but one thing you should not forget to address is the fate of your retirement accounts. In addition to the possibility of having to divide your accounts up between you and your spouse, there’s the issue of taxes to consider. For this reason, you should understand what will likely happen to your retirement accounts and how you can protect yourself from additional losses.
Dividing Your IRA
Whether by choice or by court order, you may have to divide your retirement accounts between you and your spouse a term of the divorce. Where an IRA is concerned, this is called a transfer incident to a divorce and must be filed as such to avoid paying penalties and taxes. The divorce decree will order this as either a transfer order or a rollover, but, in either case, it must be handled correctly by the IRA custodian.
This process ensures that your ex-spouse will be granted sole ownership of the funds transferred into his or her account. If your former spouse withdraws that money for any reason, this ensures that he or she will be responsible for paying the taxes on that money.
Failing to file the transfer incident correctly may leave you liable for paying those taxes, as well as subjecting you to pay penalties for early withdrawal. When the transfer incident isn’t properly filed, the IRS will assume you both still have access to the IRA funds, which means both of you will be subjected to those fines and penalties. The best way to avoid this situation is to submit the information to the IRS together, which should include the percentage of the asset division, the exact dollar amount transferred to your ex-spouse, and the account numbers for the sending and receiving accounts.
Dividing Funds Under a QDRO
A QDRO, or a qualified domestic relations order, concerns the splitting of retirement funds in plans such as a 403(b) or 401(k). While these accounts are protected against most types of seizures, a spouse can file the QDRO to claim a portion of the funds stored in the account. Much like a transfer incident, the division of these funds under a QDRO exempt those involved from having to pay taxes on the transferred funds.
In order to avoid taxes and penalties, the QDRO must be approved by the courts and the account custodian must be notified of the transaction. In order to avoid paying taxes, the receiving spouse must immediately roll all of the funds over into an IRA account or another qualifying plan. If the money is rolled into a Roth IRA, the funds will be taxed as a conversion, but the individual will not be penalized by the IRS. It’s important to ensure all paperwork is filed correctly and the transaction is approved in advance, because a transaction that’s not deemed a legitimate QDRO by the IRS will be taxed and subjected to penalties.
Don’t Forget to Change Beneficiaries
You will likely want to change your beneficiary, since you probably won’t want to name your former spouse as the primary beneficiary. If you have children, you may want to make them the primary beneficiary. One way to do this and to ensure they will receive the funds is to name a revocable living trust as the beneficiary, while naming your children as the beneficiaries of the trust. This helps circumvent the probate process and ensures your children receive the maximum amount from the funds.
Once you’ve completed the division of funds, it’s important to consider how you’ll manage the remaining funds in your account. Even though you may need to rebuild your savings, you should consider who will receive the money after your death. This is a good time to review your estate plans and make any necessary changes.
As this brief overview suggests, it may not be enough to ensure your attorney is experienced in family law matters. You gain the best possible advantage in working with a lawyer who has expertise in divorce, finance, tax law, and estate planning. By combining these separate disciplines, your attorney can ensure you get the results you want in your divorce and in planning for the future for your dependents. Above all, working with an experienced professional ensures you’re protected against paying more than your fair share in taxes.