For ex-spouses in the middle of a divorce, the burden it places on their emotions makes it difficult enough for them to live as normal a life as possible. Besides the toll on your emotions, a divorce also poses several financial problems that need to be addressed.
Aside from your most obvious assets such as the house, the car, and all other conjugal property, divorce will also mean having to divide your retirement plan assets. This process can be especially tricky, as the tiniest of errors can cause major tax problems down the road.
Add in the fact that the division of retirement assets depends on the retirement plan itself (IRA or qualified plan), and you begin to realize why hiring a divorce attorney is so important.
The Primary Issue of Divorce and Retirement Plans
Not too many people know that retirement accounts are usually the biggest liquid assets in a divorce. And because retirement plans are already tricky enough on their own, distributing them between ex-spouses can be a major tax headache.
For example, when done incorrectly, moving one ex-spouse’s IRA to the other ex-spouse’s IRA may lead to penalties of unintentional distribution. And as mentioned earlier, different rules apply to different plans like 401(k)’s and Defined Benefit plans.
- IRA Plans
Dividing an IRA plan should be approached as a transfer “incident to divorce.” The law stipulates that transfers should be done within a year after settling the divorce, with the IRS potentially reviewing any transfers after this period. Recipients will then take responsibility over the use and distribution of these assets.
Failure to classify transfers as “incident to divorce” will result in both ex-spouses incurring an early withdrawal penalty. Moreover, the sending and receiving IRA custodians, as well as the judge and state courts, must approve of any instructions from an ex-spouse on the handling of IRA transfers. Otherwise, any amount transferred to your ex-spouse will be treated as regular income and taxed accordingly.
- Qualified Plans
A qualified domestic relations order (QDRO) comes into play in any division of qualified plans between two parties. The divorcing spouse, or the alternate payee, usually receives the transfer of interest from the participant. However, this setup also applies to children.
QDROs are tax-free, provided they are reported appropriately to the IRA custodians and the courts. Like IRA transfers, labeling your transfer as a QDRO will ensure it is protected from taxes and penalties.
Another challenge of transferring retirement assets between ex-spouses is the need to add or change your beneficiaries.
With qualified plans, there’s not much you can do when it comes to adjusting your beneficiaries. In a 401(k) on the other hand, an ex-spouse needs to change their designated beneficiary, otherwise any assets will go to the ex-spouse even if it states otherwise in a will.
IRAs, on the other hand, are not subjected to state laws. This means an ex-spouse does not receive beneficiary rights automatically. Just make sure you update the designated beneficiary in your IRA plan when your ex-spouse gives up any claim to retirement assets.
For legal advice on how to divide your retirement assets in a divorce, talk to the family law team of the Lyttle Law Firm. Call us today at 512.215.5225 to schedule a consultation with a divorce lawyer.