Retirement plans are considered assets, and the marital value of these plans will have to be divided appropriately during your divorce. But there are different types of retirement accounts, and the division of them will vary by type.
Qualified versus Non-Qualified Assets
Don’t let these identifiers confuse you…all of your retirements “qualify” as assets and will be subject to division during a divorce. “Qualified” describes the type of retirement account you have, and it will impact the way the account is divided. Examples of non-qualified assets are money in your bank account, equity in your house, certain investment accounts, businesses you may own, and jewelry or artwork. Any asset that was purchased with after-tax money and is not subject to withdrawal restrictions is generally considered non-qualified.
If you have a 401(k) or 403(b) retirement plan through your employer, these are perfect examples of qualified plans. If your employer offers a pension plan instead, that is also considered a qualified plan. These are the most common, traditional examples of a qualified plan.
Contributions to a qualified account are taken out of an employee’s paycheck before taxes are deducted, thus lowering the taxable income of the employee. For example, using round numbers for illustration purposes, if an individual earns $100,00 per year and contributes $10,000 to their 401(k), they are only paying taxes on a $90,000 income. However, and this is important, when money is withdrawn from that account upon retirement, it is all taxable, including whatever matching funds the employer contributed.
Using the same example, if your $10,000 grew to $20,000 between the time it was put into your 401(k) and when you retire, the entire $20,000 is taxable since no taxes have ever been paid on that money. The theory is that you benefit from (1) being able to save more money initially since it is pre-tax and (2) being in a lower income tax bracket when you retire.
When you contribute to a traditional IRA, you can receive a tax deduction on your income that year, providing you qualify otherwise. Any gains on your account, however, will be tax-deferred, meaning you will pay taxes on your gains upon withdrawal.
It is also important to distinguish between a traditional qualified account and a Roth IRA retirement account. Contributions to a Roth IRA don’t provide any tax benefits while you are contributing to them, but when you withdraw them, the money you withdraw is tax-free, because you’ve already paid taxes on that income once. The benefit to this account is that when you withdraw the money, you pay no taxes, even on the returns you have realized. So, although you don’t receive a tax deduction for contributing, your investment is earning money for you that can be withdrawn tax-free.
Dividing Retirement Plans
Dividing a qualified asset requires a Qualified Domestic Relations Order (QDRO) to be drawn up between both spouses and their attorneys or financial experts. Once the judge signs the QDRO, it will be sent to the plan’s administrator for division. This ensures that you are not paying taxes for withdrawing money that will be transferred to your former spouse in a divorce. Your spouse now holds the “qualified” account so they will pay taxes on those funds if they withdraw the money.
Dividing an IRA is much easier than dividing a qualified plan, as a QDRO is not necessary. Traditional or Roth IRAs can be transferred with a court order, although most plan administrators have a form that you can use to transfer money from one IRA to another. Most financial institutions will request a “transfer incident to divorce”, and some might also require a copy of the divorce decree. At this point, the spouse who is to receive the money can open a new account in their name and have the money transferred into it.
Why it Matters
Taxes: The tax implications of qualified accounts versus non-qualified accounts will impact their true value, which is why it’s best to have a knowledgeable family law attorney help you through this. $100,000 in a 401(k) is worth less than $100,000 in a Roth IRA, because the 401(k) will be taxed at your current tax rate when you withdraw it. The Roth, however, is all yours, tax-free.
Penalties: In addition, if you are under age 59 ½, you may incur a 10% penalty for withdrawing funds from a 401(k) or a traditional IRA. While you can withdraw your own contributions to a Roth IRA without penalties, you cannot withdraw the earnings on that money until age 59 ½, or you will incur a penalty.
Value: Another important factor to consider is the value of a qualified account versus a non-qualified account. Because a 401(k) or Traditional IRA is subject to income tax, it will be worth less than a non-qualified account on which taxes have already been paid. For example, a $100,000 401(k) that is subject to a 10% early withdrawal penalty and income taxes might only have a withdrawal value of $70,000 for someone who is in a 20% tax bracket. Conversely, $100,000 in a bank account can be withdrawn and the entire $100,000 will be received. Because of this, it is important to understand and consider the nature of the account when discussing the specific terms of a divorce or dissolution.
Figuring out the best and most equitable division of these assets during a divorce can be complicated, which is why it’s best to have an experienced family law attorney on your side. Your divorce attorney may hire financial experts to assist if needed, but an attorney who is experienced in family law has dealt with the division of these types of assets for many years and will be able to guide you through this.
For example, will you need the money to live on now, or can you defer withdrawal? Who will pay the penalties for early withdrawal, or the taxes if either are appropriate? How much of the money was contributed before the marriage, and how much after?
If you have questions about the best way to divide qualified or non-qualified assets during your divorce, consult one of the experienced attorneys at Kirkland & Sommers for expert guidance and advice. We only focus on family law, and our lawyers have more than 100 years of combined experience. Let us answer your questions about asset division or any other divorce-related matter. Call us today or click the link below to get the conversation started.