Divorce: Your Ex-Spouse’s Rights to Retirement Benefits
It’s no secret that going through a divorce isn’t easy. In addition to all the emotional challenges involved, tricky financial decisions are in play as well. One such example? Determining how to split retirement benefits, one of the biggest (and perhaps most complicated) financial decisions you’ll ever make. Regardless of whether you’re receiving or giving up money in these accounts as part of your settlement, you’ll need to understand related rules and tax implications before finalizing your divorce to hopefully save yourself some money—and headaches—along the way.
Equitable distribution vs. community property states
If you don’t have a prenuptial agreement, arm yourself with knowledge of your family’s financial situation and any applicable laws in the state where you file for divorce to determine how retirement assets are split. For example, nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) have set out to ease the often-grueling experience of splitting assets by designating those gained during marriage as “community property” (owned and thus split equally by both spouses); assets that fall into this category often include real estate, personal property, savings/retirement accounts, and any debts acquired during the marriage.
Individual assets acquired before the marriage or inherited by one spouse (before or during the union) aren’t typically considered community property but are in fact commuted to this in some jurisdictions. One of the most common ways for separate property to morph into community property is via comingling, such as when one spouse places an inheritance into a joint bank account.
Alaska, Florida, Kentucky, South Dakota, and Tennessee have an “opt-in” community property law stating that assets are split evenly if agreed to by both parties. Every other state follows “equitable distribution,” meaning a judge will attempt to distribute assets as fairly as possible during divorce proceedings; under these circumstances, no set rules determine which spouse receives what (or how much). If you own homes in more than one state, the location of your permanent legal residence determines whether you’re subject to community property law.
How to split retirement plans in a divorce
If retirement assets comprise a significant portion of your divorce settlement, you’ll need to understand the rules governing these accounts and potential tax implications. Start by categorizing each of your retirement accounts before reporting them to the courts to help avoid potential tax and penalty complications. These categories are actually court orders that establish one spouse’s claim to a portion of the other’s retirement plan account, with account type determining the category as follows…
IRAs
IRA accounts are classified under the “transfer incident to divorce” category. If your IRA is correctly categorized, transferring funds to your ex-spouse won’t incur any taxes or penalties—with him/her taking full responsibility of the total amount after funds are transferred and then transferring or depositing them directly into an IRA within 60 days of receipt to avoid paying taxes. A failure to properly label your IRA as “transfer incident to divorce” means both of you will pay an early withdrawal penalty and taxes on the entire amount transferred.
Knowing how IRAs are taxed is also a critical component of any divorce settlement. For example, just because traditional and Roth IRA accounts each have the same dollar value doesn’t mean they’re split down the middle between spouses; with tax already paid on Roth IRA contributions, account owners can take tax-free distributions once they’re eligible (unlike traditional IRAs funded with pre-tax dollars whereby account owners must pay taxes on these funds when they begin taking distributions in retirement).
401(k)s
Qualified accounts (e.g., 401(k)s and 403(b)s) fall within the “Qualified Domestic Relations Orders” (QDROs, pronounced “quad rows”) category. A QDRO functions similarly to a "transfer incident to divorce" decree as a potentially tax-free transaction, provided the account is categorized and reported properly. The spouse receiving the transfer has a few options here including placing QDRO assets into his or her own qualified plan tax-free or rolling over funds into a Roth IRA. In the case of the latter, the amount is taxed as a conversion but doesn’t incur penalties.
It's also important to consider payout timing when splitting retirement accounts. With defined contribution plans like 401(k)s, this depends on the specific plan and its guidelines (e.g., some plans only provide an immediate lump sum payout option while others employ periodic payments or future lump sum disbursements). Knowing when payments will be received is critical for devising a budget and managing cash flow needs for life after the divorce.
Pensions
Pensions also fall under the Qualified Domestic Relations Order (QDRO) category. Similar to 401(k) plans, knowing payment timing is very important especially considering that (as a general rule) you’re only entitled to pension payouts when your spouse reaches retirement age.
Annuities
Dividing an annuity during divorce proceedings can be complicated as these financial products are often intricate and call for careful calculations. It’s also important to consider potential fees and tax implications when splitting an annuity. That said, there are two common ways of doing so:
· Withdrawal Request: This involves processing a withdrawal from the existing annuity to create two new contracts or a single contract if the annuity is awarded to one spouse.
· Surrendering the Annuity: This involves ceding part or all of the annuity and distributing the proceeds.
The method chosen, type of annuity involved, and specifics outlined in the divorce decree (such as stipulations regarding withdrawal tax treatment) all influence tax implications, fees, and benefits associated with the division. Given the complexity of these transactions, consulting with a financial advisor or tax specialist with experience in insurance products and annuities is highly advisable—especially if an annuity represents a significant portion of divorce assets.
Your ex-spouse and Social Security benefits
Divorcees who meet all requirements and apply for benefits at their full retirement age can claim up to 50% of their ex-spouse’s total benefits without impacting him/her. In order to become eligible for benefits, however, the following conditions must be met:
· You must be 62 years of age or older.
· You must have been married for at least 10+ years.
· You must be divorced for at least two years.
· You must be unmarried.
· Your ex-spouse is entitled to Social Security benefits.
· The Social Security benefits you’re entitled to based on your own work record must be less than your ex-spouse’s.
For more details, read our article on divorced spouse Social Security benefits.
Update retirement account beneficiaries
After sending or receiving retirement account assets, be sure to update beneficiaries on your retirement accounts and other financial assets since those listed on these and insurance policies generally supersede your will. In other words, regardless of what your will says, assets will pass on to listed beneficiaries (unless you list your estate as the primary one).
In sum: divorce and retirement benefits
While splitting retirement assets is sometimes complicated, remember it’s only one piece of divorce settlement proceedings. Other financial considerations include what to do with your home in a divorce, capital gains taxes, and much more. This is precisely why we recommend speaking with a financial advisor who can guide you through the divorce process and help you make sound decisions.
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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
