DIVIDING A 401(K) IN DIVORCE
Divorce itself is an emotionally-charged, troubling process. When you add major financial decisions to the mix, it can create a recipe for DISASTER. Our goal is to help clients make sense of the financial maze they face in divorce and navigate the process with confidence.
It’s no surprise that retirement plans, especially 401(k) plans, hold a significant portion of discussions in divorce cases. Many times this is a couple’s largest asset and is often used to offset other assets, like the marital home, as part of the divorce settlement.
There are several things that need to be considered when dividing a 401(k) plan in divorce.
Qualified Domestic Relations Order (QDRO)
First, you must have a Qualified Domestic Relations Order (QDRO) in your marital settlement agreement in order to divide a 401(k). A QDRO is the federally mandated tool utilized to move a 401(k) from one spouse to another spouse as part of a divorce settlement. Details for distributing funds using a QDRO will be included in your marital settlement agreement and you will also need to use an attorney to assist with drafting the QDRO, which will be an additional expense post-divorce.
How the Funds Will Be Received
Next, if a couple decides to divide a 401(k) plan during divorce, the recipient spouse can receive the 401(k) funds in one of three ways:
(1) cash,
(2) another 401(k) account, if allowed by the plan or
(3) their own Individual Retirement Account (IRA).
Cash
It is quite common that the 401(k) will be one of the largest assets in a couple’s estate.
If you decide to take funds from a 401(k) as CASH, you will be taxed on the funds as ordinary income (as if you had a job that earned as much as you are receiving in cash), but an additional 10% penalty on early distributions for anyone under age 59½ can be waived, if handled properly. If you have a 401k in your marital estate, THIS IS JUST ONE REASON WHY YOU NEED TO CONSULT A FINANCIAL PROFESSIONAL.
Also keep in mind that receiving these funds in cash will also be taking away from your RETIREMENT savings that you will need later - so consider this carefully!
QDRO Funds to a 401(k) Account
You also have the option to rollover the 401(k) funds to another 401(k) account for your benefit; in doing so, you will not be taxed or penalized until distributions are taken at retirement. Some plans will allow you to stay in the current 401(k) plan. However, keeping your funds in your ex-spouse’s 401(k) plan will also tether you to him/old life and may not be your best option.
Some plans will allow you to roll the funds into your own 401(k) plan, but this may limit your investment options and may subject you to higher administrative fees. Many clients will opt to rollover 401(k) funds to an IRA.
QDRO Funds to an IRA
If you move the QDRO funds into your own Individual Retirement Account (IRA) it will be done without taxation or penalty. You will create your own IRA. Your ex-spouse is no longer a part of this; it’s your own account invested as you see fit. If it is in an IRA, you will have no constraints on your investment selection. We advise you to consult with an experienced financial advisor to help you invest according to your own goals, time horizon and risk tolerance.
Is the 401(k) The Best Asset to Divide?
If you and your spouse have multiple assets to divide - other retirement plans such as IRAs, Roth IRAs, pension plans, investment accounts - the 401(k) plan may not be the best asset to split. Each type of asset has its own taxation based on each spouse’s tax bracket (currently and at retirement). As a Certified Divorce Financial Analyst ® professional, I can help you understand the tax implications of your financial decisions in divorce to ensure that you are making the wisest choices for you and your family.
The 401(k) is a wonderful tool to help build wealth. When you are awarded one or a portion of one in divorce, it can help you in a tremendous way, either today with cash flow or in the future for your own retirement. At The Financial Knot®, we can help you in a variety of ways with the financial portion of your divorce settlement, including whether or not to give or receive 401(k) plan funds. Call our office today for a consultation to discuss your specific needs, goals and circumstances.
The Financial Knot® is another business name for Independent Advisor Alliance, LLC. All financial planning advice is offered through Independent Advisor Alliance, LLC, a registered investment advisor.
