In my previous blogs, I’ve described the divorce process from a timeline point of view: considering divorce, legal choices and the financial steps in divorce. Now let’s focus on an area where one or both of the divorcing individuals can make mistakes with significant economic consequences: division of assets.
Divorce is less emotional if you can treat it as a business transaction, at least in determining an equitable division of assets.
It is surprising how many divorce settlements end up less than equitable, due to a lack of fully understanding the distinctions between assets.
Here are some major points to help you understand various types of accounts as you consider division.
IRAs: IRAs and SEP IRAs are funded with pre-tax dollars and grow tax-deferred, so when money is withdrawn from these accounts, you will owe tax based on your ordinary income tax rate. It is important to understand that this tax due on IRA assets means that a dollar of IRA money is not necessarily equal to a dollar from a brokerage (taxable) account. For those younger than 59 ½, there is also a 10% penalty for withdrawing from an IRA, so if this were the only asset you received in divorce and you are under 59 ½ years old, in order to use the funds immediately, you’d have to pay the taxes and penalty. When splitting an IRA due to divorce, there is no tax due as long as it is done by direct transfer to another IRA and not as a withdrawal. To divide an IRA pursuant to divorce, most custodians require a copy of the divorce decree and specific instructions on the division, security by security.
Roth IRAs: These retirement accounts are funded with after-tax money, grow tax-deferred and in most cases distributions are not taxed. They too can be split as above, but because you may be able to withdraw from these accounts without any tax being due, every Roth dollar is more desirable than a dollar in an IRA.
401(k)s and 403(b)s: The tax consequences of 401(k)s and 403(b)s are similar to IRAs, but as qualified retirement plans, in order to divide them, you must obtain a Qualified Domestic Relations Order (QDRO). A QDRO is a special court order that grants a person a right to a portion of the retirement benefits his or her former spouse has earned through participation in an employer-sponsored retirement plan. QDROs are typically prepared by a lawyer during divorce proceedings and are specific to each employer plan. Usually, a separate account is set up at the employer-sponsored plan for the non-participant. Once established, it can remain there or be transferred by direct rollover to an IRA. It is important to understand that there is an additional cost to establish a QDRO and depending on the plan, it can take a while. In the division process, it sometimes makes sense to avoid the QDRO process by allocating another retirement asset to the non-participant in lieu of 401(k) funds.
With qualified plans, there is one exception to the 10% penalty for early withdrawals: at the time of the divorce, the non-participant is allowed to withdraw funds from the 401(k) without penalty, assuming he/she does so before the non-participant account is set up and before his/her portion of the funds are reinvested. Ordinary income tax is still due on any funds withdrawn, but the 10% penalty can be avoided. Ideally, retirement accounts should not be used for pre-retirement cash flow needs, but this exception does offer a limited window of time to access cash for those cases where the non-participant has legal fees to pay or needs to finance living arrangements and has no other sources of funds.
Defined Benefit Plans (Pensions): A defined benefit retirement plan promises to pay the employee a certain amount per month at retirement based on service and compensation. It has no cash value today, which means it can be more complicated to value. A QDRO is used to divide a pension, equally or unequally depending on the divorce decree.
There are several approaches to dividing pension benefits. In the case where the employee spouse worked for the company before marriage, a calculation is used to determine what fraction of the pension is a marital asset. The non-participant can receive a lump sum payment or another marital asset based on a calculation of the present value of future payments. Or if the non-participant finds the idea of a fixed income payment for life appealing, he/she can choose to receive a percentage of the monthly benefit at the time that it is paid out (usually retirement or age 65).
A Side Note on Beneficiary Designations: Very important! Retirement accounts and whole life insurance policies have named beneficiaries who are designated to inherit an account or life insurance proceeds. At death, these assets are distributed according to the listed beneficiaries and not by the will. Usually in marriage, one names his/her spouse as the primary beneficiary, with children as contingents. The process to change beneficiaries is not difficult but is often overlooked as the divorce concludes. It is strongly encouraged that you change beneficiaries as soon as the divorce is final to avoid unwanted situations later.
Taxable (Brokerage): These investment accounts are funded with after-tax savings and income and capital gains distributions are taxed annually. In addition, if you sell a holding that has increased in value since purchase, you will pay capital gains tax on the difference between what you paid for the security (cost basis) and its value the day it is sold. Capital gains tax rates are less than ordinary income tax rates.
This is important to be aware of as you divide taxable accounts in a divorce. The cost basis and the potential capital gains exposure may be different for each holding in a taxable account. As such, the most equitable way to divide a taxable account in divorce is by designating the percentage of each holding that each spouse will receive. Dividing the taxable assets in this manner makes the date of division less important since each party will receive half of the overall account on the date that the account is split.
Making It Happen
The negotiation process to agree on a division of assets can be one of the more difficult parts of getting over the finish line in finalizing your divorce. Yet, once the negotiation is completed, there is an important step still to go which involves making sure that the assets due to you are properly moved into accounts in your name. While one might expect this to be part of your lawyer’s final responsibility, it is more often than not up to you. Each situation is certainly different, but an ex-spouse may not be in a hurry to release half of his/her retirement account or your joint taxable account, so you will need to request that transfer, and follow up to make sure it happens. A clearly written divorce decree with specifics on asset division makes this transfer of assets easier. Your financial advisor can also be instrumental in helping you with follow up.