How a 401(k) Is Split In a Divorce
The division of a 401(k) during a divorce depends on various factors, such as the value of the total marital assets, and the balance of each person’s 401(k).
Let’s discuss equitable distribution and community property to understand this better.
- Equitable distribution requires that marital property acquired during the course of the marriage be divided in a fair manner, but it may not necessarily be divided equally.
- In community property states, the law indicates that both spouses equally own all financial assets acquired during the marriage, and, after counsel with divorce attorneys, a judge may aim to split everything 50/50.
In both states, money a person puts into their 401(k) before getting married is not considered marital or community property and will not be distributed to an ex-spouse.
If one spouse has a larger amount of savings than the other spouse, there may be a chance that a court order may require the spouse with more savings to give a portion to the other spouse.
What is a QDRO and How Does It Work?
A QDRO (Qualified Domestic Relations Order) is a legal document in a divorce decree that acknowledges a dependent, such as a spouse, former spouse, or child, is entitled to receive a portion of the account owner’s retirement assets. A QDRO is commonly issued in court.
A QDRO gives the “alternate payee” a part of another individual’s retirement savings. The amount they get depends on how much the partner has saved compared to what they will receive when they retire, as well as the total financial picture of both spouses.
QDRO withdrawals do not involve early withdrawal penalties and help ensure a fair distribution of retirement account plan assets.
401(k) Taxes In a Divorce
In a divorce, a spouse can roll over their share of the 401(k) account into their own Individual Retirement Account (IRA) or their own retirement 401(k) tax-free. Taxes on this money will only appear when the new owner starts taking distributions.
If a spouse decides to withdraw a lump sum instead of rolling it over, they will have to pay income tax on the amount drawn, which may result in an early withdrawal penalty. This is similar to the IRS guidelines for withdrawing early from any retirement account.
What Happens to Your Other Retirement Savings in a Divorce?
Divorce proceedings can also impact different retirement funds that a spouse may have, such as pension plans, traditional IRAs, savings accounts, and other retirement benefits.
Let’s take a closer look at each type of retirement savings and their unique implications during a divorce:
- Pension plans: Similar to a 401(k), pension plans may also be subject to division during a divorce. The court may determine the ex-spouse’s entitlement to a portion of the pension plan based on the length of the marriage and other factors.
- Traditional IRA: In a divorce, a traditional IRA may be divided using a process similar to a QDRO, with the funds transferred to the other spouse’s IRA account. This avoids early withdrawal penalties and potentially expensive tax consequences.
- Roth IRA: Roth IRAs are also subject to division in a divorce. The division process is similar to a traditional IRA, with the ex-spouse receiving their share of the assets in a separate Roth IRA account.
To navigate these complexities, it is essential to consult with a family law attorney who can provide guidance on tax-deferred retirement benefits and help you make informed decisions during the divorce process. Primarily, an experienced attorney will help avoid accidental cash outs, which can be expensive from both a tax and penalty perspective.
Tips for Dividing a 401(k) in Divorce
When dividing a 401(k) in the case of divorce, consider the following tips to minimize the loss in retirement savings due to excessive taxes and fees.
Avoid Unnecessary Expenses
Be mindful of tax consequences when dividing a 401(k). Whenever possible, opt for a rollover rather than a cash-out to prevent early withdrawal penalties and additional taxes, like income taxes.
Work Out an Independent Agreement
If both parties can agree on property divisions without court intervention, consider creating a prenuptial agreement or postnuptial agreement to outline the terms of the 401(k) division and make the process run smoothly.
Engage with Financial Advisors
Seek guidance from financial advisors to better understand state laws, tax implications, and the long-term impact of 401(k) division on your retirement saving.
Get help to avoid tax penalties if you are entitled to a portion of an ex-spouse’s retirement fund.
Seek Legal Advice
Consult a divorce lawyer or a law firm specializing in divorce settlements to ensure you understand your rights and obligations regarding the 401(k) division. State laws vary in how they treat 401(k) investments in a divorce, so understand the nuances of your situation in advance.
In Summary
Dividing a 401(k) during a divorce can be complex, with tax implications and varying entitlements for each ex-spouse. It’s essential to seek professional help and advice during this difficult time.
Although you may consider a 401(k) an individual account, often, an ex-spouse will be entitled to a portion of retirement savings. That portion may also be tax-free if rolled over directly into a retirement account.
Capitalize is a trusted partner that can help you navigate the complexities of retirement account rollovers during a divorce or any other life change.
We partner with you to make the process simple. Learn how Capitalize can help you set up your financial future.
