Retirement accounts, such as 401(k)s and IRAs, often represent significant assets in a marriage and are commonly subject to division in a divorce. Because these accounts are tax-deferred, dividing them requires careful planning to avoid tax penalties and ensure that both parties’ retirement savings goals are protected. One of the tools for dividing these accounts is a Qualified Domestic Relations Order (QDRO), which allows for the transfer of 401(k) funds without triggering taxes or early withdrawal penalties. Retirement accounts and issues are particularly important in gray divorces.
Why Are Retirement Accounts Marital Property?
In Colorado, any income or assets accumulated during the marriage are typically considered marital property, regardless of which spouse’s name is on the account. This means that the value accrued in retirement accounts like 401(k)s or IRAs during the marriage is subject to division upon divorce. Retirement savings, which may represent decades of contributions, are often one of the largest assets to be divided. These accounts also include a variety of other retirement plans, such as 457 plans, 403(b) accounts, Thrift Savings Plans, pensions, SEP IRAs, SIMPLE IRAs, profit-sharing plans, Cash Balance Plans, and defined benefit plans, each with unique rules and considerations for division in a divorce.
What is a QDRO?
A Qualified Domestic Relations Order (QDRO) is a legal court order that allows for the division of a 401(k) or pension plan between divorcing spouses. The QDRO gives the non-account-holding spouse the right to receive a portion of the retirement funds (what QDROs often call an “alternate payee”). Importantly, the QDRO allows for the division without triggering early withdrawal penalties if the receiving spouse opts for a direct transfer into an IRA.
If the non-participant spouse needs immediate access to the funds, they can take a lump-sum distribution, which will be subject to income tax but not the early withdrawal penalty, provided they are under the age of 59½. This is a unique situation that applies when spouses are divorcing and rolling over a retirement account using a QDRO.
Options for Dividing 401(k) Accounts with a QDRO:
Direct Rollover to an IRA: The most common option is to roll over the non-participant spouse’s share of the 401(k) into their own individual IRA, preserving the tax-deferred status of the funds.
Lump-Sum Distribution: The non-participant spouse can choose to take a lump-sum distribution from the 401(k). While this avoids the early withdrawal penalty, it will be taxed as income.
Dividing IRAs in a Divorce
Unlike 401(k)s, IRAs do not require a QDRO for division. Instead, the spouses can agree to transfer funds from one IRA to another as part of the divorce settlement. The division of IRAs can be executed through a transfer that changes the account’s ownership, provided the funds are intended for the former spouse. Like with 401(k) accounts, the goal is to avoid early withdrawal penalties.
If the divorcing parties decide on a lump-sum cash-out from an IRA, there will be income tax on the withdrawn amount, and if the recipient is under 59½, the IRS will also impose a 10% early withdrawal penalty.
Risks of Cashing Out Retirement Accounts Early
Divorcing spouses sometimes face immediate financial pressures and may consider cashing out part or all of a retirement account to cover living expenses, legal fees, or other costs. However, cashing out a retirement account early can lead to significant financial consequences, including:
- Income taxes on the full amount withdrawn
- 10% early withdrawal penalty for those under 59½
- Loss of valuable retirement savings that can compound over time
In cases where a spouse decides to cash out, it is crucial to consult with an attorney or financial advisor to understand the tax implications and ensure the withdrawal aligns with long-term financial goals.
The Role of Attorneys and Financial Advisors in Dividing Retirement Assets
The division of marital property, particularly retirement accounts, is one of the most challenging aspects of a divorce. Because each spouse’s retirement savings can significantly affect their future financial stability, it is important to approach the division carefully. An experienced divorce attorney can help ensure that you comply with the relevant legal requirements and avoid costly mistakes, such as violating a temporary injunction by withdrawing funds prematurely.
Additionally, working with a financial planner or tax professional can provide valuable insights into the long-term impact of different division strategies. For instance, while taking a lump-sum distribution may provide immediate cash flow, it could result in a higher tax liability, reduced retirement savings, and penalties that would otherwise be avoidable through a direct rollover.
When Retirement Accounts Are Partially Separate Property
In some cases, a portion of a retirement account may be considered separate property and not subject to division. This typically occurs when:
- The account was inherited by one spouse, either before or during the marriage.
- The account was acquired before the marriage.
For example, if one spouse had a 401(k) account with $50,000 before the marriage, and it grew to $150,000 during the marriage, the initial $50,000 is generally considered separate property, while the $100,000 growth would be marital property subject to division. It is essential to properly trace the origin of the funds and document the growth to ensure the proper allocation of marital versus separate portions.
There is a case called In re Marriage of Powell that addresses the tracing of retirement accounts. 220 P.3d 952 (Colo. App. 2009)
Market Fluctuations and Risks of Allocating Gains and Losses During the Transfer Process
One significant risk when dividing retirement accounts is the potential for market fluctuations between the time an agreement is reached and when the actual transfer takes place. Preparing a QDRO can take months, and in that time, the value of the account may change due to market performance. For instance, if the stock market drops, the account value could decrease significantly by the time the QDRO is finalized, leaving the non-participant spouse with a smaller share than expected.
To mitigate this risk, divorcing spouses can negotiate how to handle gains and losses that occur during the transfer process. Common approaches include:
- Freezing the account balance as of the date of the agreement, so the non-participant spouse’s share is based on the value at that time, regardless of future market fluctuations.
- Sharing the gains and losses proportionally, where both spouses benefit or suffer from any market changes during the transfer period.
Both options have advantages and drawbacks, depending on market conditions and the nature of the retirement assets. It’s important to consult with a financial advisor or attorney to determine the best approach based on the specifics of the case and the assets involved. When the market suffers a downturn, issues can arise.
Contributions and Gains/Losses After the Agreement
Once an agreement is reached, any contributions made to the retirement account by the participant spouse, as well as any gains or losses on those contributions, should generally remain the property of the contributing spouse. For example, if the participant spouse continues to contribute to a 401(k) after the divorce agreement is signed, those contributions, along with any associated growth, should not be subject to division under the QDRO.
However, it is crucial to ensure that the QDRO is drafted to clearly delineate the cut-off date for the division of assets. This prevents disputes over post-agreement contributions or market growth on those new contributions. Proper language in the QDRO can safeguard both parties from future misunderstandings. Ambiguous language leads to issues and disputes.
Safeguard Your Retirement in Divorce
In a divorce, dividing retirement accounts like 401(k)s and IRAs requires careful consideration of tax implications, long-term savings goals, and each spouse’s financial needs. Using a QDRO to divide a 401(k) or transferring an IRA without penalties is the most effective way to protect retirement savings. Taking a lump-sum distribution should only be considered in situations where immediate cash flow needs outweigh the long-term consequences.
If you’re facing the division of retirement assets in a divorce, consult with your attorney and financial planner to explore your options and determine the best course of action for your future. At Griffiths Law, we help guide clients through the complexities of property division, ensuring retirement accounts are allocated fairly and correctly.
Christopher Griffiths is a Shareholder and Chief Financial Officer at Griffiths Law—a law firm specializing in family law and civil litigation.
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