Going through a separation or divorce is hard enough on its own, but the situation grows even more complicated when it comes to money. One of the more confusing aspects of the financial ramifications of divorce pertains to retirement savings. Generally, spouses will need to split retirement assets, but the process behind this is not always clear. In some cases, one spouse will maintain an asset entirely. Understanding this process is key to handling the tax implications, as well as reformulating a strategic plan to get individuals where they want to be when it comes time to retire. The key determinant in how an asset is divided has to do with the type of account it is.

IRAs are handled differently than qualified plans, even when two former spouses agree to split both types of assets in the same way. Individuals divide an IRA using a “transfer incident to divorce” claim, while qualified plans, including a 401(k), require a QDRO, or Qualified Domestic Relations Order. Sometimes, courts will use one of these terms to cover both types of assets, but the paperwork must be in the proper order with the right designations to avoid additional headaches and hurdles down the road. With either assets, individuals need to remember to update their beneficiaries, although some divorce decrees require keeping a former spouse on the paperwork.

 

Key Points for IRA Asset Division

When dividing an IRA, it is important to treat the transaction as a transfer incident to divorce in order to avoid taxes. Without this declaration, both parties may end up losing money unnecessarily. The IRA custodian will classify the transaction as either a transfer or a rollover depending on the ultimate decision on the division of assets, as well as the wording of the official decree. After the transaction is completed, the recipient becomes the legal owner and that person will need to deal with any tax consequences arising from future distributions or the movement of funds. In other words, the former owner of the account does not face ramifications for how the new owner manages the funds, so long as the label “transfer incident to divorce” is used.

However, if the division is not properly labeled, the current owner will end up paying taxes and early withdrawal penalties on the entire amount received by the new owner. In order to avoid mislabeling, it is important to include both the division percentage breakdown and the dollar amount of assets being transferred. Furthermore, all sending and receiving IRA account numbers should be listed to avoid any confusion. Both sending and receiving IRA custodians need to agree with what the language indicates, in addition to the judge handling the case.

 

Special Situations with IRA Division

The courts must approve the division agreement or else the IRS will consider the amount sent to the recipient as ordinary income. Also, the recipient will not be able to place the funds in an IRA since it would not be an eligible transfer, and the tax deferral benefit is lost. Sometimes, recipients will demand compensation for that loss.

Another special situation occurs if the IRA being transferred was funded in part by nondeductible contributions. In this case, both parties will need to calculate the dollar amount of nondeductible contributions and report this on Form 8606 to the IRS. This form is very important, and calculations can prove tricky, so sometimes it makes sense to hire a professional for assistance. Otherwise, both people may pay unnecessary taxes down the line.

 

divorce paperwork

Considerations of Qualified Retirement Plans

When it comes to qualified retirement plans, particularly a 401(k), individuals need to understand the specific technicalities. Federal law provides a wide range of protections for these assets, but some notable exceptions involve seizure and attachment by creditors and lawsuits. Both divorce and separation proceedings make it possible for someone to ask for attachment of qualified plan assets through a QDRO. Such an order divides qualified retirement plan assets among formers spouses and/or children and dependents.

Like transfers incident to divorce, QDROs eliminate tax obligations, provided that they get correctly reported to both courts and IRA custodians. Through this order, the recipient has a wider variety of options. The funds can be transferred to a new or existing qualified plan, or they can be deposited into a traditional or Roth IRA. In the latter case, the money is taxed as a conversion but is not penalized. Any sort of transfer that does not fall under the QDRO umbrella will incur both taxes and penalties, so getting the right paperwork in order is extremely important.

 

The Takeaway Message

In the end, dividing retirement assets in a divorce can seem complicated, but it does not need to be provided that individuals do their homework and accurately report all information. The primary concern needs to be to get a transaction declared as a “transfer incident to divorce” or QDRO in order to avoid tax consequences. All custodians, as well as the courts, need to agree with these declarations. Lacking attention to detail in this matter could mean that the process becomes much more expensive and time-intensive than necessary.