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What Happens to My Retirement Accounts in a Divorce?

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What Happens to My Retirement Accounts in a Divorce?

Divorce Law Separation Tax

Retirement accounts is another divorce tax issue that concerns divorced couples. Whether you have a pension, 401(k), or some other form of retirement savings plan, you have undoubtedly worked hard to build up your savings. You likely have plans for this money and may fear that your retirement may be delayed or indefinitely halted due to the consequences of a divorce. The good news for individuals with these concerns is that there are typically a lot of options to divide retirement accounts between divorcing spouses. However, this is balanced by the fact that many retirement accounts have fairly complex rules regarding their division and some are unable to be divided at all. Due to these complex rules, the handling of the division of retirement accounts can be a compliance nightmare and should only be handled by a tax professional. In most cases, a divorce attorney will refer out this part of the work to a tax and financial professional or a tax attorney.

What Should I Expect When a Retirement Accounts Contains Benefits from Before and During the Marriage?

When a retirement benefit to be split is made up of both premarital and post-marital earned benefits, a “coverture fraction” is used to determine the portion of retirement benefits earned during the marriage. The numerator of the “coverture fraction” is the total period the participant spouse was in the plan during the marriage. The denominator of the ‘coverture fraction” is the total time the participant was in the plan from their year of enrollment up until the cessation of marriage (ordinarily the date of legal separation).

Where a defined contribution plan is to be divided, the “coverture fraction” is converted to a percentage and then multiplied by the account balance to determine the value of the account that is attributable to the marriage that is to be divided. Where a defined benefit plan is to be divided, the “coverture” percentage is multiplied by the projected monthly pension benefit earned from plan enrollment to the date of separation to determine the portion of the projected monthly benefit earned during the marriage. The present value of the projected monthly pension benefit earned during the marriage can also be calculated in a similar manner.

How Is the Retirement Account Divided?

Where a retirement benefit is legally capable of being divided and an offset out of another marital property is not desired or not possible to the spouse not entitled to a pension benefit, a qualified domestic relations order (QDRO) can be drafted by a legal professional with experience in this field (often assisted by a CPA).

QDROs are court orders directing a retirement plan administrator to pay benefits to an alternate payee (non-benefit earning spouse). QDROs are commonly used for most qualified plans such as 401(k) or 403(b) pension plans.  Plans divided via a QDROs are ordinarily free of immediate tax consequences via Code Section 1041.  Benefits are taxable to the recipient as ordinary income.  QDRO prohibited from requiring the plan to do anything for the non-benefit earning spouse that it does not already provide its existing plan participants. For instance, QDRO will not be honored where drafted to pay out a lump sum if it the plan does not offer a lump-sum payout option to its other plan participants. QDRO is executed by the divorce court and then supplied to the plan administrator.

The plan administrator ultimately determines whether the QDRO meets the plan’s requirements so it’s a great idea, where possible, to have plan administrators preapprove a draft QDRO before it is ultimately served on the court for execution. This type of careful planning can increase the likelihood that a division of a retirement account will be approved by the plan administrator.