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Retirement Perspectives

Make sure you understand the rules for splitting different types of retirement accounts.

While it’s widely understood that around 50% of marriages in the United States end in divorce*, I still receive quite a few questions about how retirement accounts are split in the process. Dividing retirement assets when a marriage ends can be tricky, due to the different set of rules that apply to different types of accounts, and compliance is key to preventing unwanted penalties and taxation. Below is an outline that a retirement account owner should follow when transferring retirement accounts pursuant to a divorce.

As part of a divorce settlement, you potentially could receive a portion of the funds in your ex-spouse’s retirement plan. How the assets are divided or split depends upon the type of retirement plan funds. (Remember: different rules apply to qualified plans versus IRAs.) To transfer qualified plan assets such as a 401(k), a qualified domestic relations order (QDRO) is the necessary document. IRAs (including SEPs and SIMPLEs), however, are split according to the divorce agreement, not a QDRO. To state this in another way, a QDRO does not apply to an IRA.

Qualified Plans
Like IRAs, funds from a qualified plan (e.g., 401(k), 403(b)) cannot be distributed and given to a spouse without being subject to income taxes and/or penalties.  However, unlike IRAs, qualified plans cannot be split by a divorce agreement. Instead, a QDRO is forwarded to the plan’s administrator for review. Once the QDRO is approved by the plan administrator, the former spouse (referred to as an alternate payee) will have options, depending on the plan’s provisions. A common distribution option is to take the funds directly from the plan; however, this would be a taxable distribution. Notably, the funds received from a plan pursuant to a QDRO are not subject to the 10% early distribution penalty for early distributions. A second option is to roll over the funds to a traditional IRA. If the receiving spouse (alternative payee) is over the age of 59½, or doesn’t need the funds, this option usually is the best. It’s important to check the summary plan description (SPD) for specific plan rules. Why? A QDRO cannot force a plan to do anything plan rules do not allow. In other words, a QDRO cannot force the plan to offer  an option that is not a plan provision. For example, it’s possible an ex-spouse might have to wait for the plan participant to retire before being able to take a distribution.

Tip: Once plan assets are rolled over to an IRA, they no longer are exempt from the 10% penalty; any distributions taken before age 59½ would be subject to an early withdrawal penalty along with income tax, unless another exception applied.

IRAs (Including Roth, SEP, and SIMPLE)
Government rules are clear: an IRA cannot be transferred during the life of the account owner. How, then, would an account owner go about transferring an IRA during a divorce? The only exception to the “no transfers during life” rule is for a transfer to an ex-spouse as part of a divorce settlement. However, this exception requires going to court and producing legal documents stating you are no longer married.

You can’t simply take a distribution and give the proceeds to an ex-spouse. Not only would those funds no longer be in an IRA but also you would have to pay income tax and, if applicable, the 10% penalty for early distributions. That’s not good for anyone. Instead, if an IRA is to be split as part of a divorce, the split must be included in the divorce agreement. Generally, IRAs are included in property settlement agreements between married couples who divorce.  However, IRA assets can be transferred from one spouse to the other on a tax-free basis only if allowed under a court-approved divorce decree or legal separation agreement.

That document subsequently is given to the IRA custodian. Then, the IRA can be split into shares for both parties, or transferred entirely to the ex-spouse—if that is what was agreed upon—in a tax-free transfer. The IRA owner is left with an IRA, although it is smaller than it was before, and the ex-spouse also has an IRA. This is the only way to split an IRA in a divorce that is a nontaxable event. The funds should be transferred directly via a trustee-transfer to the ex-spouse’s account. Then, if he or she takes a pre-age 59½ distribution, he or she will be responsible for any applicable tax and penalties. There is, however, no exception to the 10% early distribution penalty for IRA funds received pursuant to a divorce.

Previously, same-sex married couples did not have  spousal IRA benefits of different-sex married couples. These benefits now include tax-free splitting of IRAs in a divorce, and spousal rollovers at death. Anytime a distribution is taken from either a qualified plan or an IRA without a QDRO or a divorce decree and the proceeds are “given” to a former spouse, a taxable distribution has occurred.

What else do I need to know about splitting retirement accounts in divorce?

  • For IRAs, the divorce decree should be specific about the amount and timing of the split.
  • QDRO’s apply to only qualified plans – not IRAs.
  • Contact the IRA custodian to determine the process of splitting an IRA to ensure a nontaxable transaction.
  • An ex-spouse who already has an IRA can transfer to that IRA the proceeds pursuant to a divorce. There is no requirement to establish a new or separate IRA.
  • RMDs are not affected. The prior-December 31 value is not adjusted to determine in the year of divorce.
  • Form 1099-R will not be created.
  • There is no required reporting to the IRS.
  • Always update beneficiary forms post-divorce.
  • Marital status is determined the last day of the year.

* Source: American Psychological Association.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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