Divorce Mistakes to Avoid When Dividing Retirement Assets

The most sensitive part of dividing property in a divorce often involves retirement assets. Instead of splitting traditional retirement assets equally, the more thoughtful approach is to consider the real needs of spouses after a divorce and assess the long-term benefits of a particular retirement asset.

Reaching these improved results will require the assistance of a lawyer familiar with the legal processes involved in the division of non-qualified and qualified retirement assets under the Employee Retirement Income Security Act (ERISA).

Standard private-sector retirement plans in the US are designed to receive favorable tax treatments under the ERISA, which allows plan funds to be taxed only until the plan participant withdraws them. To protect these tax benefits, the federal government prohibits participants in an ERISA-qualified plan to make early withdrawals of retirement funds without being subjected to penalties.

There is, however, an exception for plans divided for child support, alimony, and division of marital assets, which can only be done through a qualified domestic relations order (QDRO). QDROs come into play when dividing ERISA-qualified plans involved in divorce, but aren’t necessary in the division of individual retirement accounts and other similar non-qualified plans, like pensions, stock ownership plans, and deferred compensation plans.

To avoid making expensive mistakes when dividing these assets, your divorce lawyer should be able to recognize these issues.

  1. Expect tax liabilities on distributions from QDRO transfers

A simple rollover from a plan participants qualified contribution plan—such as a 401K—to the ex-spouse’s retirement account is considered non-taxable. When the spouse chooses to take a portion or all of the benefits in cash, however, this can lead to two taxation scenarios:

  • A possible assessment of a fine for early distribution
  • Income tax liability triggered by the early distribution.

While the income tax can’t be avoided, it’s possible to circumvent the penalty for early distribution on transfers by QDRO, provided the alternate payee chooses to receive the cash while also choosing the form of distribution before the benefit rolls over to another plan.

  1. Set Parameters on Dividing the Pension Plan

The former spouse can receive a very different post-divorce outcome depending on the following methods of dividing the pension plan and the options chosen for survivorship.

  • Shared Interest Method – Tends to benefit the plan participant
  • Separate Interest Method – Tends to benefit the former spouse

A divorce lawyer will try to obtain the most favorable terms for their client, which may cause conflict. Advisors should also work to ensure both parties receive the most beneficial survivorship options.

  1. Split the parameters of after-tax contributions to each spouse’s contribution plans

When the plan participant has been allowed to make pre-tax and after-tax contributions to the plan, advisors should address this issue when dividing assets. A lawyer should define the benefits to the former spouse for including a pro rata tax parameter for after-tax contributions. A recently IRS ruling now makes it easier to change 401K after-tax contributions to a Roth IRA.

Learn more about the intricacies of dividing retirement assets by consulting with Lyttle Law Firm. Visit our website or call our offices at 512-215-5225 to schedule a consult.