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Retirement Perspectives

Since 40–50% of all U.S. marriages break up,* many nest eggs also get broken. 

Divorce proceedings can be traumatic. While the emotional toll itself is hard enough to deal with, there also are number financial traps for the unwary, especially when it comes to retirement accounts. For example, a client could be awarded some or all of his or her former spouse’s retirement accounts, such as an IRA or 401(k).

A legal separation most likely will involve the division of a variety of financial assets, such as a primary residence, taxable accounts, and trusts, to name a few. But if retirement plan assets are not divided properly, there could be big financial issues (read: taxes). Depending on the type of plan—IRA, 401(k), or a qualified plan—the rules may differ. So, be sure to consult a financial and/or tax professional on such difficult matters.  

Avoiding Further Pain  
Retirement accounts frequently are an individual’s single largest asset in a divorce proceeding, other than a primary residence. So, make sure you understand the many complex rules on dividing such assets. Failure to transfer funds from one spouse’s account to a former spouse can trigger taxes and penalties.

Suppose, for example, your divorce settlement allows you to receive a portion of the funds in your ex-spouse’s retirement plan or account. How the assets are divided or split depends upon the type of funds, and different rules apply to qualified plans, such as 401(k)s, versus IRAs. To transfer qualified plan assets such as a 401(k), a qualified domestic relations order (QDRO) is required, whereas all IRAs (including Roths, SEPs, and SIMPLEs) are split according to the divorce agreement. In other words, QDROs do not apply to IRAs.

An individual, by means of a QDRO, can transfer his or her qualified plan assets or 403(b) to his or her former spouse without being subject to income taxes and/or penalties. Once the court has issued this document, it must be forwarded to the plan’s administrator, which must review the order. Upon accepting the order, the receiving spouse, known as the alternate payee, will have different options, depending on the plan’s unique provisions.

Once the plan administrator approves the QDRO, the former spouse typically is given the option to roll over qualified plan assets into an IRA tax free, or take a distribution subject to income taxes. Note: Distributions from a qualified plan pursuant to a QDRO are exempt from the 10% early distribution penalty, thus allowing a former spouse younger than age 59½ to receive penalty-free distributions.

Now, here’s where you need to exercise caution. Government rules do not extend to IRAs the aforementioned penalty exemption, because once the assets are rolled over into an IRA, they no longer are exempt from the 10% penalty on early distributions, so any funds taken before age 59½ would likely be subject to an income tax and an early-withdrawal penalty.

As previously stated, QDROs do not apply to IRAs. Further, 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?

IRA funds can be transferred tax free from one spouse to the other only if allowed under a court-approved divorce decree or legal separation agreement. Generally, IRAs are included in property settlement agreements between married couples who divorce. Why? Tax law prohibits all IRAs to be transferred or gifted while the account owner is living. The sole exception: IRAs that are split as part of a divorce—one where you go to court and have documentation that clearly states that you are no longer married.  Without documentation (e.g., a divorce decree), there is no legal authority for the IRA to be split or divided. Generally, the decree will contain the necessary verbiage or language stating the amount of funds the former spouse will receive.

Either the divorce decree or a separation agreement that is incorporated as part of the divorce will spell out who gets what part of the IRA. After the divorce is granted by the court, you would give the separation agreement or divorce decree to the IRA custodian. Then, the IRA account can be split into shares for both parties, or transferred entirely to the ex-spouse, if that was agreed upon, in a tax-free transfer. The IRA owner would be left with a smaller IRA than before, and the ex-spouse would also have an IRA. This is the only way to split an IRA in a divorce that is a nontaxable event.

Key Takeaways
Remember: you can’t simply take a distribution and give it to a current or ex-spouse. Not only would those funds no longer be in an IRA but also you would have to pay the tax and, if applicable, the 10% penalty for early distributions.  

If an IRA is to be split as part of a divorce, the split must be included in the divorce agreement. After divorce is final, forward the divorce agreement to the IRA custodian in order to process the division of IRA assets. The funds should be transferred directly to the ex-spouse’s IRA. Then, if he or she takes the proceeds outright, at least he or she will be responsible for any applicable tax and penalties. There is, however, no exception to the 10% penalty for IRA funds received pursuant to a divorce.

Also remember that any time an individual takes a distribution from either a qualified plan or an IRA without a valid QDRO or a divorce decree and “gives” the funds to his or her “ex,” a taxable distribution has occurred, and the “ex” would no longer have a tax-advantaged retirement account—just cash! So, be extra careful about how you break up nest eggs in divorce proceedings.

* Source: American Psychological Association.

 

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.

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.

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 Simplified Employer Pension (SEP) is an IRA based plan that allows small business owners and their employees to save for retirement on a tax-deferred basis.

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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