Divorce, with its emotional baggage, is something most people want to put behind them as quickly as possible. Couples challenged with figuring out who gets what, resolving custody issues and determining how the divorce will impact each partner’s lifestyle may prefer to put off dealing with more distant concerns such as splitting up retirement assets.
Financial advisers say this can be a big mistake.
“The No. 1 issue relating to retirement assets is taxation,” says Howard Hook, a CFP professional and CPA at Access Wealth Planning in Roseland, N.J.
When all of the interest from an individual retirement account is to be transferred, it can usually be done by simply changing the name on the account. If it will be divided, the amount going to the partner or ex-partner who does not own the account should be transferred into a new or existing IRA in that person’s name.
“The IRA transfer is generally outlined in the divorce decree or property settlement agreement,” says Marguerita Cheng, a CFP professional with Ameriprise Financial in Bethesda, Md. “Funds are transferred directly from one spouse’s IRA to the other spouse’s IRA.”
However, although such transfers made as part of a divorce settlement are not considered taxable, Hook says, “They must be transferred in the correct way,” as outlined in the agreement. “Otherwise, it will be considered a full distribution of those assets, and there will be tax consequences.”
The best way to go is with a direct transfer of assets from one IRA to another, says Tracy Stewart, a CPA and CFP professional whose practice focuses on divorce issues. “With a trustee-to-trustee transfer, your spouse will not risk being taxed on the distribution to you, and you will not be taxed on the transfer,” she says. “These transfers are only tax-free if they are specifically required in the divorce decree, separate maintenance or written agreement incident to a divorce.” Any other transfers pertaining to separation or temporary support will result in a taxable transfer, she adds.
Cheng emphasizes that it’s very important to discuss the specific situation with a qualified tax professional before proceeding with the transfer — and to make sure all the details are in order.
“Contact the financial institution that serves as the custodian of the IRA to find out its procedures for IRA transfers,” she advises, “and be certain to verify that the settlement agreement includes detailed and specific information regarding the account number and financial institution for each IRA.”
Timing is also crucial. If the funds are transferred before the divorce is final, Hook says, and the original owner of the IRA is younger than 59 ½, he or she will be subject to a 10 percent early withdrawal penalty.
One way to ensure that the funds in a retirement account are distributed correctly is through a qualified domestic relations order, commonly known as a QDRO.
“A QDRO is a legal document that divides an individual client’s retirement account with a spouse, an ex-spouse or a dependent,” says Cheng. “In effect, a QDRO allows money inside such plans to be distributed to another owner without incurring the taxes and penalties normally associated with a transfer.”
QDROs generally apply only to retirement assets held in workplace plans such as 401(k)s, 403(b)s or traditional pension plans. Although transferring or dividing a traditional or a Roth IRA does not require a QDRO, Cheng says, using one is a good idea because the transfer won’t trigger unnecessary taxes and penalties.
“Big dollars are potentially at stake,” Hook says. “You could lose almost half of the retirement account if it’s done wrong.”
For example, when the intent is to divide all assets in half, this should be stipulated in percentage terms in the QDRO. If, instead, the agreement states that each will get $50,000 of a $100,000 retirement account and then the bottom falls out of the market, the ex-spouse would still get $50,000, and the account holder would be left with nothing.
“You need to consider what your needs are to know what assets to take over,” Hook says. “There may be other sources of income to consider.” For example, lesser-earning ex-spouses are entitled to Social Security spousal benefits if the marriage lasted at least 10 years, as long as he or she is 62 or older and has not remarried.
The distribution of most pension plans is governed by beneficiary designations stipulated by the account holder. It’s important to update these designations after a divorce to be sure your intentions will be honored, says Jennifer Immel, senior vice president at PNC Wealth Management in Naples, Fla.
“Many states have laws that automatically terminate a former spouse as a beneficiary on IRAs and other retirement plans that pass by beneficiary designation, without any action on the part of the asset owner,” Immel says — but a recent U.S. Supreme Court decision makes it clear that, at least for federal retirement plans and benefit programs, relying on those state laws is bad planning.
The court ruled that, since federal law cannot be superseded by state law, the only way to remove a former spouse as beneficiary under a federal benefit program is to formally change the beneficiary listed on the beneficiary designation form.
“Although this applies specifically to people with some kind of a federal benefit,” Immel says, “it’s a good wake-up call because there are so many other ways that outdated information on beneficiary forms can cause pitfalls. Even if people have beautifully constructed wills and trusts that make their wishes clear, pension plans or annuities are going to be governed by these beneficiary documents.”
While a good financial adviser will specifically ask about retirement assets to make sure they are coordinated with the rest of the estate plan, Immel says, “Individuals need to keep good records. These days, by the time a person is in their late 40s, he or she may have six or seven different retirement plans. You need to keep track of all of them.”