Retirement accounts are often the most valuable—and least understood—assets in a divorce. There are many different types of retirement accounts, including 401(k) plans, pensions, deferred compensation plans, IRAs, and profit-sharing plans.
Just as with a checking or savings account, it does not matter which person’s name appears on the account statements. If contributions were made to a retirement plan during the marriage, those contributions are considered community property, and they must be divided fairly between the spouses at the time of divorce.
These are the questions your attorney needs to answer in order to protect your interests when dividing a retirement account.
What Type of Retirement Account Is It?
The process for dividing a retirement account starts with a simple question: what type of retirement account is it? Generally speaking, there are two types of retirement assets: defined contribution plans, and defined benefit plans.
The most common defined contribution plan is a 401(k). Defined contribution plans allow the accountholder to deposit money into the account at regular intervals. That money is typically invested and grows or shrinks depending on the specific investments held within the account. Most defined contribution plans are pre-tax assets, meaning the accountholder will pay taxes on any money withdrawn from the account. There can also be tax penalties if an accountholder withdraws funds before reaching a specific age.
Defined benefit plans are pensions. Unlike a 401(k), a pension is not an account with a specific dollar amount invested inside of it. Instead, a pension is a guaranteed stream of income that the retiree can receive for life once he or she reaches retirement. That income stream is not calculated based upon the amount the employee contributed to the pension. Instead, it is calculated based on a formula that considers the length of employment and the employee’s average salary.
What is the Value of the Retirement Account?
Defined Contribution Plans – The value of a defined contribution plan can be determined by looking at the account’s monthly or quarterly statements. An attorney must know how to account for any premarital contributions to the retirement account as well as any contributions made after the date the petition for divorce was served. This can be a complicated mathematical question.
Divorcing couples often exchange property as a way to minimize the possibility that either may have to make a cash payment to the other. Further mathematical calculations are needed in this scenario to account for the fact that the funds in a defined contribution plan are almost always tax-deferred.
Defined Benefit Plans – One of the most common mistakes made by self-represented individuals and attorneys alike is to calculate the value of a defined benefit plan by simply adding up the amounts the employee has contributed to the pension. This method is not appropriate. It always results in a devaluation of the retirement account.
There are two ways to determine the value of a defined benefit plan. The first is known as the cash-value method, in which the present-day value of the pension is calculated as a lump sum. This method has the benefit of resolving both parties’ interest in the retirement account immediately at the time of divorce, but it has two significant drawbacks:
- First, divorcing couples rarely have enough other assets with which to buyout the non-employee spouse’s interest in the pension as a lump sum.
- Second, the lump sum method cannot calculate the actual value of the account with precision. It can only estimate the value.
This is because of the nature of a defined benefit plan. Unlike a 401(k), a defined benefit plan pay a monthly benefit for the life of the retiree (and sometimes beyond if there is an eligible survivor). Without knowing the exact date of the retiree’s eventual death, it is impossible to know how much the plan will ultimately pay out to the retiree.
The second method for valuing a pension is known as the reserved jurisdiction method. With this method, the attorney calculates a formula for determining the non-employee spouse’s percentage of the monthly benefits payable under the pension plan. The non-employee spouse will receive his or her share of the pension once payments can be made. This leads us to the next question…
When Are Pension Benefits Payable?
There is a distinction between private pension plans and public sector pension plans. Private pension plans are becoming less common in the United States, but some companies still offer them to their employees. Public sector pension plans are offered by local, state, and federal employers and include such plans as Arizona State Retirement System, Public Safety Personnel Retirement System, Federal Employee Retirement System, and military retirement.
Private pension plans allow the non-employee spouse to elect a separate interest method, which allows the non-employee spouse to begin receiving pension payments at the earliest available opportunity. Public sector pension plans generally do not allow this. A non-employee spouse cannot begin to receive payments from a public sector pension until the employee actually retires.
What Happens if an Employee Decides to Keep Working Beyond Retirement Age?
If the court order does not use a separate interest method when dividing a pension, the non-employee spouse has no control over when he or she will receive their money. What can be done if the employee-spouse decides to continue working past retirement age?
In those cases, it may be possible for the non-employee spouse to ask the court to order the employee to make direct payments in the amount the non-employee spouse would otherwise be receiving from the pension plan had the employee retired when eligible. It is critical that the attorneys address this question at the time of divorce.
What Happens if the Employee Dies Before Benefits are Paid to the Non-Employee Spouse?
Most—but not all—retirement accounts include some kind of death benefit. It is imperative that this benefit is addressed in the order dividing the retirement account.
What are the Tax Consequences of Dividing a Retirement Account?
When done correctly, there are no tax consequences for dividing a retirement account at the time of divorce. It is even possible to withdraw funds from certain kinds of retirement accounts at the time of divorce without incurring an early withdrawal penalty. Income tax would still apply to such withdrawals.
What is the Process for Dividing a Retirement Account?
Dividing a retirement account is a multi-step process, and mistakes at any one of these steps can be disastrous for either (or both) spouses.
- Disclosure of the retirement assets. The first step is to identify the retirement assets owned by each spouse. This is known as disclosure.
- Finalizing the divorce decree. The second step is the divorce decree. If the parties are settling their divorce, it is important that the divorce decree contain specific language addressing the exact kinds of retirement assets to be divided.
- Preparing the domestic relations order. The administrator of the retirement plan will need instructions for how to divide the retirement account. These instructions are known as a Domestic Relations Order. You may sometimes see this kind of order referred to as a QDRO, but that is a misnomer. Technically, a Qualified Domestic Relations Order (or, QDRO) is a subset of Domestic Relations Orders that only applies to private pensions.
This is the most important step in the process. Domestic Relations Orders are highly technical and should only be prepared by an attorney who is knowledgeable in how to draft these kinds of orders.
- Preapproval of the Domestic Relations Order. Once the Domestic Relations Order is prepared, it must be submitted to the retirement plan administrator, so the administrator can preapprove it.
- Signing of the Domestic Relations Order by the court. Once the Domestic Relations Order is preapproved, it can be submitted to your judge for his or her signature.
- Implementation of the Domestic Relations Order. The signed order is then delivered to the retirement plan, so they can implement the order.
Can a retirement account be garnished?
Yes. A retirement account can be garnished, but only to satisfy outstanding obligations for child support and spousal maintenance. The garnishment order is in the form of a Domestic Relations Order.
Please note that the information in this article only covers the most basic information about the division of retirement accounts in a divorce. There are hundreds of different retirement plans in existence, and each has its own set of rules and procedures. It is important that you speak with an attorney before your divorce is final if there are retirement assets at issue.