How Retirement Accounts Are Divided During Divorce

When facing divorce, dividing marital assets is one of the most critical and complex tasks. Among these various asset types are retirement accounts, which often require specific attention. These accounts represent years of work and may be subject to unique rules that make them particularly challenging to accurately value and divide equitably.

Types of Retirement Accounts

Not all retirement accounts are created equal. Some are employer-sponsored, others are individually managed, and they vary in both tax implications and withdrawal limitations.

401(k) Plans: Employer-sponsored, tax-deferred accounts where participants contribute part of their salary toward retirement.
Individual Retirement Accounts (IRAs): There are two primary categories of IRAs: Traditional and Roth. Traditional IRAs offer tax-deferred growth, while Roth IRAs are comprised of post-tax contributions and offer tax-free withdrawals in retirement.
Pension Plans: Although they’ve become less common, pensions provide guaranteed income in retirement. Their value often depends on years of service and salary history, making them difficult to accurately calculate compared to account-based plans.
Non-Qualified Executive Compensation Plans: These benefits are more common among high-level executive employees. These plans are often difficult to divide and require additional consideration within the divorce agreement

Each type of retirement account is subject to different rules, so understanding these distinctions is critical during divorce proceedings. Failure to do so could result in costly mistakes or an inequitable division of assets.

Dividing Retirement Accounts During Divorce

Dividing retirement assets involves more than just balancing numbers. It also requires meeting certain legal requirements to ensure that the process is done correctly. One such tool that is used in this process is a Qualified Domestic Relations Order (QDRO).

What is a QDRO?

A QDRO is a legal document that dictates the division of certain retirement plans during a divorce. A QDRO is required when dividing pension plans as well as 401(k) and similar defined contribution plans pursuant to a divorce and can affect the terms within the separation agreement. A QDRO is not required for IRAs, but other post-divorce documentation may still be necessary to facilitate the division of these accounts.

The QDRO should be prepared and filed as soon as possible following the divorce. Failing to do so may result in loss of benefits should one spouse decide to remarry or pre-decease the other.

Tax Implications

Since many retirement accounts involve tax-deferred savings, withdrawals are often taxed as income in retirement. When valuing and dividing these asset types, both parties should account for potential tax liabilities. Failing to account for these implications can result in the unintentional and disproportionate division of assets, even if it appears balanced on paper at the time of divorce.

For example, dividing a $100,000 401(k) account evenly may seem straightforward, but the eventual withdrawal will be subject to taxes and reduce its overall value. In contrast, a Roth IRA with the same balance can be withdrawn tax-free, potentially making it more valuable at the time of withdrawal. It is important to note that a withdrawal from a 401(k) by QDRO is exempt from the 10% early-withdrawal penalty. This provides a uniquely specific window for the recipient spouse to access the funds early. A Certified QDRO Specialist™ can assist you with these little-known provisions during the process.

Key Considerations

Before finalizing the asset division component of your agreement, there are several factors that divorcing couples should consider, including:

Age & Timing: If one party is far from retirement, they may prefer immediate liquidity over long-term retirement savings. On the other hand, an individual who is closer to retirement may prioritize retaining these retirement accounts to ensure financial security in their later years.
Future Cash Flow: Pensions provide steady future income but are not always transferable, requiring trade-offs. Accounts such as a 401(k) or an IRA can also impact cash flow due to certain tax penalties or the need for a QDRO to appropriately allocate benefits, making it important to consider how withdrawals, contributions, or the reallocation of assets could affect the future financial stability of both parties.
Tax Savings & Penalties: Transferring funds from a 401(k) or employer-sponsored plan usually requires a QDRO to avoid standard tax penalties. Transfers from a traditional IRA are often penalty-free if they are part of a divorce agreement, though taxes may apply when withdrawing funds later on. Differences in tax brackets should also be considered, as the recipient may face a higher or lower tax rate compared to their spouse.

Every situation is unique, so it’s important to look at both the short and long-term financials when assessing how best to divide your retirement accounts.

Final Thoughts

Divorce can be a complex process. Dividing marital assets while also navigating the emotional toll it may bring can lead to sub-optimal financial outcomes. Mistakes made during the asset division process could have long-term consequences, so working with a Certified Divorce Financial Analyst™ is advised to help ensure a fairer and more equitable outcome and safeguard your financial well-being as you move into your next chapter.

If you are contemplating divorce or seeking guidance on how to reach the optimal outcome, please reach out to schedule a consultation.

Disclosure: The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The principals of Divorce Financial Solutions, LLC are also investment advisor representatives of, and offer investment advisory services through Concord Wealth Partners, LLC, an SEC-registered investment advisor. Divorce Financial Solutions, LLC is not an investment advisory firm.