Almost no one plans their retirement with divorce in mind, but it happens. The U.S. Census Bureau reports that divorce rates are highest among people aged 55-64 — those just ready to retire.
Gray divorce, as it’s called, can be financially devastating for new retirees. One in five divorced women over 65 live in poverty, and women in this demographic are less financially secure than their divorced or widowed counterparts. Divorced women who rely on their former spouse’s retirement accounts can be hit the hardest.
Let’s take a look at what happens to retirement funds in a divorce.
Definition of Retirement Funds
Broadly speaking, retirement planning means identifying income goals for post-working life and creating a plan to meet those goals. A retirement plan might include saving a portion of income, paying off debt, managing risk, investing assets, and Social Security and/or pension strategies.
Within the scope of retirement planning, retirement funds refer to the savings and investment accounts that individuals establish to provide financial support during their retirement years. These funds can include various types of accounts such as 401(k) plans, 403(b) plans, 401(a) or 457 deferred compensation plans, individual retirement accounts (IRAs), government Thrift Savings plans, pensions, and other investment vehicles.
How Retirement Funds Are Divided in a Divorce
In Arizona, retirement funds are considered marital property if they were earned or accumulated during the marriage. This means that any retirement savings or benefits accumulated during the marriage are considered part of the couple’s joint assets and are subject to division between the spouses in a property settlement.
The specific laws governing the division of retirement funds vary by the type of plan. For example, 401(k) plans, 403(b) plans, and other defined benefit or defined contribution qualified plans are governed by the federal law called the Employee Retirement Income Security Act (ERISA), while IRAs are not.
In Arizona, the court will typically use a process called “equitable distribution” to divide the retirement funds, as well as all the marital assets. Under this process, each spouse will receive assets that roughly equal a 50/50 split. However, the Court has broad discretion in awarding assets. This means that the court will not necessarily split the retirement funds equally, but will instead aim to reach an equitable division of the assets. This is why you will need a qualified family law attorney and likely a divorce financial expert on your team. They can help ensure that you get the best settlement possible, advocating on your behalf for a favorable asset split.
A Qualified Domestic Relations Order (QDRO) is needed to order the plan administrator of an ERISA plan to divide the plan between the spouses. A QDRO is a Court order that directs the plan administrator to divide the retirement funds according to the terms of the order. This document is specific to each plan and must comply with the plan’s rules and regulations, as well as the state and federal laws that govern the plan. It must be prepared by a special attorney that handles QDROs and must be signed by both parties and the judge.
Potential Tax Implications for Asset Division
The division of assets in a divorce can have significant tax implications, as different types of assets are taxed differently. Some common tax implications to consider include:
- Capital gains tax: If assets such as stocks, real estate, or mutual funds are transferred to one spouse as part of the divorce settlement and have built-in gains (i.e., assets that have appreciated in value), capital gains taxes may be incurred when the assets are sold.
- Income tax: If assets such as retirement accounts (401(k)s, IRAs, etc.) are divided, taxes and/or penalties may be owed on any distributions taken from the account. For example, if one spouse is awarded a portion of the other spouse’s 401(k) in a divorce, they could be required to pay income taxes on any withdrawals they take from the account. There is a special penalty exception for withdrawals from 401(k) by a non-employee spouse under age 59 ½ that offers some planning opportunities.
- Sale of home: Section 121 of the Internal Revenue Code allows for a $250,000 exclusion from taxable gain on the sale of a primary residence if (1) the home was owned and used as the primary residence for two of the previous five years, and (2) the gain exclusion was not taken in the previous two years. There are special rules that allow for a reduced exclusion amount due to divorce, so talking to a CPA or divorce financial expert is key. Also, the gain exclusion is per person, so if you sell the home jointly (even if you are no longer married) you can each exclude a gain of $250,000. If you keep the home post-divorce and sell it yourself later, you will only be able to exclude $250,000.
- Alimony: Spousal maintenance payments are NOT considered taxable income for the recipient and are NOT tax-deductible for the payor. The Tax Cuts and Jobs Act (TCJA), which was enacted in December 2017 changed this. Previously, the payor received a tax deduction and the recipient was taxed on the payments.
- Child support: Child support payments are NOT considered taxable income for the recipient or tax-deductible for the payer.
It’s important to keep in mind that tax laws can change, and it’s recommended that you seek the advice of a CPA to understand the specific tax implications of your divorce settlement. Lucky for you, I am a CPA!
It is also important to note that the transfer of assets between spouses as part of a divorce settlement is typically not considered a taxable event. This means that the transfer of assets between spouses as part of a divorce settlement does not itself create a taxable event.
Rollover Options for Retirement Assets
The term “rollover” means transferring retirement assets from one retirement plan to another. Some types of rollovers are tax-free, while others are taxable, so be careful and get the advice of a CPA before completing any rollovers. For example, if you are awarded a portion of your former spouse’s 401(k) plan, you have the option of rolling it over to an IRA at a custodian of your choice, rather than leaving it with the employer’s plan. This may be desirable because it may offer lower costs and a wider selection of investments. Plus, it is a step toward separating your accounts from your former spouse’s.
However, if you are under age 59 ½ and will need to take distributions from the plan, it is better not to roll it over so that you can avoid the 10% penalty under a special rule for non-employee spouses and 401(k) plans. Another type of rollover is from a traditional IRA to a Roth IRA (also known as a Roth conversion), which is a taxable event, but may be a good tax planning strategy if you are in a low tax bracket post-divorce and may be in a higher one later when you retire. Roth IRA distributions are tax-free in retirement.
It’s important to note that there are rules governing how a rollover must be executed in order to receive tax-free treatment. A direct rollover” means that the funds are issued directly from the sending account to the new account and never received by the account owner. This guarantees tax-free rollover treatment for IRA-to-IRA rollovers and 401(k)-to-IRA rollovers. Sometimes, the sending custodian will issue a check to the owner that must be forwarded directly to the new custodian and NOT cashed to receive direct rollover treatment. If the check is cashed, it can still be deposited into the new account within 60 days to qualify as an “indirect rollover” and still receive tax-free treatment. It’s a good idea to consult a financial professional before making any decisions regarding a rollover to ensure that it is handled properly.
Protecting Your Rights to Retirement Funds During a Divorce
In 2019, the Association of Divorce Financial Planners found that 95% of women do not consult a financial expert during a divorce. Yikes! But it gets worse…
Among divorced women 30% said they were not familiar with their retirement plans and 40% claimed not to understand their investments. About 60% of women said they did not know they needed a financial planner, and 30% said they couldn’t afford one. But in hindsight, nearly 2 in 3 women wished they had worked with a financial planner during their divorce. Having a divorce financial expert on your team should be viewed as an investment in your financial future. I offer a Satisfaction Guarantee package of services where I will refund my fees if I am not able to improve your settlement by at least the amount of my fees. That’s a money-back guarantee! So, you have no risk and only stand to gain!
Let’s take a quick look at the relative benefits of negotiating the financial aspects of divorce on your own versus working with a professional.
Options for Negotiating an Agreement on Your Own
When dividing retirement funds in a divorce, it’s important to consider factors such as whether the funds were acquired during the marriage–in whole or in part, potential tax implications, your age and retirement needs, and your financial situation. Make you have access to information and reach your best settlement.
If you and your spouse are able to come to an agreement without seeking outside assistance, you will still want to have an attorney draft the agreement and review it on your behalf to make sure nothing was overlooked. You should also get expert tax and financial advice to ensure that tax carryovers, filing status, dependents, etc. have been properly determined. Once you sign the property settlement agreement, it will be legally binding so be sure that you understand and agree to the terms before signing.
If you are unable to agree on a settlement, seek professional legal and financial/tax assistance. Remember, the divorce process can be complex.
Benefits of Seeking Professional Assistance
A CPA or Certified Divorce Financial Analyst® professional like me can help you to understand the financial implications of any agreement and that the agreement itself is equitable-both in value and in tax implications. I can also provide guidance on navigating the often-complex process of dividing retirement funds.
Furthermore, I can advise and guide on tax implications and potential penalties for early withdrawals from retirement accounts. I can also identify and evaluate all assets, including retirement plans and pensions, and create an accurate and comprehensive picture of the parties’ financial situation, which can be essential for reaching an equitable settlement.
Overall, a divorce financial expert can provide the necessary knowledge and advice to navigate the complex process of dividing retirement funds during a divorce and can help to ensure an equitable outcome.
How a Professional Can Help You Protect Your Retirement
1. Gathering all relevant financial documents
An expert, such as a divorce financial advisor, can help you identify and gather all the relevant financial documents, including retirement account statements, income tax returns, and other financial records, that will be necessary to complete the required Affidavit of Financial Information (AFI) and understand the full picture of your assets and liabilities.
2. Understanding the tax laws that apply to your retirement funds and other assets
A Certified Divorce Financial Analyst® expert can help you understand the laws and regulations that apply to your retirement funds, including ERISA plans like 401(k)s or 403(b)s and other qualified plans, as well as IRAs and other non-retirement investment accounts.
3. Understanding the different types of retirement funds
An expert can help you understand the different types of retirement funds that may be included in your divorce settlement and the best ways to divide them.
4. Understanding the tax implications
An expert can help you understand the tax implications of the division of assets and help you plan accordingly
5. Negotiating a fair settlement
An expert can, with your attorney, help you negotiate a settlement that protects your interests and ensures a secure financial outlook.
6. Preparing and file all necessary legal documents
Your attorney will help you by preparing and filing all necessary legal documents, such as a QDRO, which may be required to divide certain types of retirement funds.
Would you like to know more about how you can protect your retirement funds during divorce? Give us a call at (480) 378-2383 and schedule your free 30-minute consultation today!