When going through a divorce, the process of dividing assets can be a frustrating and confusing one. Retirement assets are an important issue in any divorce proceeding, since, after the marital home, they often represent the largest category of marital assets to be divided in a divorce settlement. Accounts that fall into this retirement category include IRAs, 401(k)s, 403(b)s and even future pension benefits provided by an employer’s defined benefit plan. Some families may have accumulated large IRA accounts from previous employer pensions or many years of savings.
Note that the process of splitting IRAs due to a divorce is very different than that of a 401(k), 403(b) or a defined benefit pension plan. All 401(k)s, 403(b)s and defined benefit pension plans are qualified plans governed by ERISA 1, and therefore require filing a legal document with the plan administrator to protect the spouse’s rights and future benefits. This filing is called a Qualified Domestic Relations Order (QDRO). See our separate article on QDROs.
How to Divide an IRA in Divorce?
An IRA can be split during a divorce, but several conditions must be satisfied to ensure optimal tax treatment. Federal tax law allows tax-free transfers if these conditions are true:
- The IRA transfer is provided for in your divorce decree or property settlement agreement, AND
- The funds are transferred directly from one spouse’s IRA to the other spouse’s IRA.
If an IRA is moved without following these rules exactly (even if there is a Divorce), the IRA holder will owe federal income taxes plus a 10% penalty on the transferred amount if under the age of 59½. This can create major financial implications and stress. Thus, it is vital to ensure that an IRA is properly divided in a divorce proceeding.
What is a Transfer Incident to Divorce?
Dividing an IRA between spouses can be a relatively simple process if it is treated as “a transfer incident to divorce” per the divorce agreement. Once the court approves the designated share of assets for each spouse, the custodian will require the filing of the custodian-specific paperwork along with documentation of the order that is found in the divorce settlement. The IRA custodian then transfers the funds via an internal transfer or a rollover.
If done properly, no tax would be assessed on the separation and the movement of funds to the receiving spouse’s account. This is due to the simplified and less regulated structure of the IRA account. The goal with the “transfer incident to divorce” is for neither spouse to be taxed on or subject to an early withdrawal penalty on the transfer. However, if the process is not labeled correctly with the custodian, it will have negative consequences that include the referenced tax and penalties. It is recommended to work closely with the custodian and an advisor during this process to avoid mistakes on either party’s side.
Strategies when Splitting an IRA in Divorce
There may be several other tax and financial planning considerations to review before deciding how to split an IRA in divorce. A few common items to review when splitting an IRA in divorce include:
- Using the same financial institutions as your former spouse. This may lead to a quicker transfer and easier procedures. This may be important if you want IRA funds to move quickly.
- Reviewing beneficiaries of IRA accounts. Be sure you update the beneficiary designations on your own IRAs, retirement plans and life insurance policies when you divorce.
- Understanding the tax treatment of an IRA account. Remember that IRA accounts are often pre-tax money. There will be tax consequences when funds are withdrawn, and this is not the same as receiving assets in an after-tax brokerage account.
Conclusion: Comprehensive Divorce Financial Planning
When finalizing a divorce, it is possible to procrastinate or forget to initiate some of these transfers amid all the other changes happening in your life. However, it is important that these matters get addressed and that changes are made as quickly as possible, since delaying could jeopardize these assets.
Once the transfers are complete, it is a worthwhile exercise to also review the beneficiaries on all the applicable accounts. This can be coordinated with your estate attorney or RTWM Wealth Advisor to ensure your estate plan wishes will be carried out as desired.
Splitting retirement accounts during a divorce is important, however, there may be many other financial planning considerations to review during a divorce. Cash flow analysis, estate planning, asset allocation and income tax planning is also critical. Working with a Certified Divorce Financial Analyst (CDFA®) is crucial to avoid pitfalls during this process. Be sure to make the necessary inquiries and consult with a Round Table Wealth Advisor to identify any planning opportunities that may arise from your divorce.