Retirement Plan Division – The Details
Simply put, any asset or liability that was acquired during the marriage is considered marital property, and must be shared by the parties upon the dissolution of the marriage. Everything will be divided, from bank accounts to time-shares and even frequent flier miles. Retirement accounts are also subject to division, sometimes even if the plan was started prior to the marriage. The following example illustrates how a retirement plan that was initiated before marriage would still be subject to division.
John started contributing to a 401(k) plan offered by his employer in 2000. Later, in 2008, John married Sarah and continued to have a percentage of his wages diverted to his 401(k) each pay period. John and Sarah split up in 2014, and begin dividing up marital assets. In this case, Sarah would be entitled to a portion of the value of John’s 401(k). The value of the contribution made to the 401(k) during the eight years the couple was married would be considered marital. Each one of those contributions from John’s paycheck was considered a contribution from marital funds, and thus Sarah would be entitled to a portion of the balance of the 401(k).
Identifying that a portion of the 401(k) is marital and subject to distribution is the easy part. The difficulty often lies in determining what amount of a retirement account is considered marital. There are several issues to consider – is the account fully vested? Were some funds contributed prior to the marriage? Does the employer-contributed amount factor into the equation? Placing a value on the marital portion of a retirement account can be rather difficult.
Valuation of Retirement Accounts
Some retirement plans are relatively easy to value, while others prove more difficult. If a spouse opened an IRA during the marriage, with marital funds, then the full balance of the IRA would be considered marital and would be split evenly between the spouses.
Now consider something more difficult, a pension plan. Let’s say that a husband and wife get married in 2005. The husband had been working at Company X since 2000, and continues to work there today. The couple decided to separate in 2010. How would you determine how much of the pension is marital property and how much is separate property?
In North Carolina there is a simple math equation, known as the coverture fraction, that helps determine how much of a pension, deferred compensation benefit or other employer based retirement plan is marital, and thus subject to division. Simply divide the length of time a spouse was simultaneously married and contributing to the pension plan by the total length of employment during which the pension was earned. In applying this formula to the example above our equation would look like:
5 (years pension contributions coincided with the marriage) / 10 (years husband contributed to pension prior to separation).
In this example, 50% percent of the husband’s pension plan is marital property. So 50% of the value of the pension would be subject to distribution, and the wife would be owed 25% of the value of the plan.
Defined benefit plans can be even more difficult to value. For these plans, the amount paid at retirement is typically based on the salary of the employee’s last years of work. So if a couple is separating and the spouse with the defined benefit plan is only 35, how can you place a value on what the plan is really worth? This is undoubtedly trickier. In these situations, the courts will apply a five-step process to determine the value of a defined benefit plan:
- Determine the earliest date that the spouse can retire.
- Determine the life expectancy at the date of separation to determine how many months the employee-spouse will get the benefits.
- Determine the value of the pension at the earliest retirement date.
- Discount the value to the date of separation (figure out the future value and discount that value to the date of separation).
- Determine any contingencies that may occur and discount the value further.
As you can see, determining the value of a defined benefit plan can be complicated and is largely speculative. Depending on the plan, it may be appropriate to hire an expert to dig into the numbers and come up with a value to associate with a retirement plan.
Distributing a Retirement Plan
Once a value is assigned to a particular retirement plan, and it has been determined what portion of the plan is marital, then the spouses will have to consider the various options for actually dividing the plan.
Generally speaking, when spouses make transfers to one another incident to divorce, the transfers are tax-free. So, if a husband needed to transfer $100,000 in cash to his former wife in equitable distribution, that lump sum transfer would be tax-free. Accordingly, if a wife had to transfer a vehicle to her former husband, that transfer would be tax-free. The IRS has a specific rule that allows transfers, that otherwise may be subject to gift taxes or capital gain taxes, to be tax-free so long as the transfers are between spouse and incident to divorce.
Typically a provision will be included in the legal document discussing the transfer, stating that any transfer will be tax-free. However, even if transfers occur with no legal document in place, there is often a presumption that the transfer was “incident to divorce” and therefore is free of tax consequences. In order for this presumption to take effect, the exchange of property must be related to the end of the marriage, or take place within one calendar year of the end of the marriage. Bear in mind that even if the transfer is prescribed by a legal document, it must occur within 6 years of the end of the marriage or the transfer will no longer be considered tax-free.
The problem with this rule is that it is not truly all encompassing. Certain transactions involving certain types of assets will automatically trigger a tax event, regardless of this rule. Retirement accounts are a prime example of an asset that is not directly protected by this rule. If a spouse were to simply cash in a 401(k) account in order to split it with his former spouse because of a divorce, the simple act of withdrawing from the 401(k) would create a taxable event.
There are ways to protect oneself from experiencing a major tax penalty when trying to divide a retirement account, however. For instance if you need to split the balance of an IRA, it can be done tax-free if you adhere to the following rules.
1. Individual Retirement Accounts
Transferring an Individual Retirement Account (IRA) incident to divorce can be simple, but care should be given to transaction because if it is not handled properly the transfer could result in a costly tax penalty. When such a transfer takes place as prescribed by a divorce decree or other written instrument related to divorce, the IRS has mandated that such a transfer is not to be treated as a “distribution.” Normally, withdrawing funds from an IRA would be treated as a distribution. If done properly, an IRA transfer will simply result in the ownership of the IRA funds having changed hands, and no penalty will be assessed.
First, the party transferring the IRA funds should transfer them directly to their former spouse. If instead, the spouse takes a check from the IRA balance to give to their former spouse, it will be treated as a distribution and taxed as such. Also, if the transaction is handled in this manner, the spouse receiving the funds will not be able to put the full balance in a tax-deferred IRA account. Be sure that the bank representative handling your transfer treats the transaction as either a transfer or a rollover in order to avoid it being labeled as a distribution.
If your former spouse already has an IRA open, the funds can simply be transferred or rolled over into the open account. If not, he or she will need to open an IRA to accept the funds. Transferring the funds into a non-IRA account will create a taxable event. Be aware that a SEP IRA, which is established by an employer and is a form of an employee retirement benefit, has different rules that apply when transferring the funds. Those accounts need to be transferred by use of a Qualified Domestic Relations Order, which is outlined below.
2. Qualified Employer Plans
For qualified employer plans such as 401(k)s, pensions, and SEP IRAs, the best way to ensure that transferring all or a portion of the funds to a former spouse doesn’t result in tax penalties is to obtain a Qualified Domestic Relations Order (QDRO).
A QDRO, simply put. is a legal instrument that allows for a person to assign rights in a retirement account to another person. This order will allow the account to be separated and withdrawn with no tax penalty, so long as the funds are deposited in another retirement account. The order itself will be sent to the plan administrator after it is signed by a judge, and it will instruct the administrator as to how the funds are to be dispersed.
Keep in mind that simply addressing how the account should be split in your separation agreement will not give you the same result – the plan administrator will not disperse a share of the plan without a valid QDRO. Similarly, if the owner of the qualified plan simply withdraws the funds directly from the plan to disperse them it will trigger a taxable event. Not only will taxes be owed because of early withdrawal, but the withdrawal could even propel that spouse into a higher tax bracket, cause other investments to be hit with surtaxes, and even cause some of the exemptions the spouse would be otherwise eligible to take hit the phase-out threshold. This domino effect can easily be avoided by executing a valid QDRO.
Obtaining a QDRO is essentially a separate legal process, and therefore can increase your legal fees and is not something that happens overnight. Typically the spouse who is receiving the funds will be the spouse required to pay the legal fees necessary to obtain the QDRO, and it will be that spouse’s attorney who does the legwork in creating and filing the QDRO. Because obtaining a QDRO can increase legal fees, the spouse entitled to receive funds from the other spouse’s retirement account will often accept another asset of comparable value in lieu of the retirement funds. For example, if a spouse is entitled to $100,000 from her husband’s 401(k) plan, she might prefer to take a lump sum in that amount from a non-retirement account, or even receive an asset worth $100,000, like a boat, condo, jewelry or the like rather than going through the process of obtaining a QDRO.
3. Non-Qualified Plans
Non-qualified plans are employer-sponsored plans that do not adhere to ERISA guidelines. Typically, these plans are reserved for select employees who have specialized retirement needs; only high-ranking and highly paid employees are given non-qualified plans.
The vast majority of these plans cannot be touched by a QDRO, and can almost never be divided or assigned to a spouse. The issue with these plans is that they typically include a provision which explicitly prevents the plan from making payments to anyone other the employee – which means that regardless of what a court order or other legal instrument says, there is no way to make payments directly to a former spouse from a non-qualified plan.
If a non-qualified plan exists, and at least a portion of the plan is considered martial, the attorneys should determine whether the plan is divisible or not prior to the completion of settlement negotiations. If the plan is not divisible, then the spouse entitled to a portion of the plan should receive the value she is entitled to in other ways, or enter into an agreement which prescribes a transfer to take place once the employee-spouse actually receives payment from the plan (usually at retirement). The problem with the latter course of action is that if the employee is still a ways off from retirement, then there are very complex tax issues that develop regarding how future payments are calculated and ultimately taxed.
Failing to address how to divide a non-qualified plan prior to reaching a settlement agreement can be a big mistake. If a QDRO attempts to divide a non-qualified plan, and the plan does not allow for such, the spouse entitled to receive a portion of the plan is generally left with no recourse.
4. Military Retired Pay
Military Retirement is also treated as marital property and thus is subject to division. If the “10/10 requirement” is met, the former spouse can get direct payments from the Defense Finance and Accounting Service (DFAS). “10/10” requires that the spouses must have been married 10 years or more during which the military-spouse had at least ten years of applicable service. However, even if the 10/10 requirement is not met, the court can still order a division of military retired pay, the benefit of meeting the 10/10 requirement lies in the fact that the former spouse can get direct payments from DFAS.
Military pay is a federal entitlement, which does not fall under the umbrella of qualified plans, and therefore a QDRO is not necessary to divide the funds. A division can be addressed in a divorce decree, separation agreement, or other court order, without the need to obtain a QDRO.
In order for the former spouse to gain access to the military retired pay, he or she will need to submit an application adhering to the Uniformed Services Former Spouses Protection Act (USFSPA) guidelines. The application will need to include a copy of the court order, certified by the clerk of court, as well as a completed DD Form 2293.
5. Other Government Retirement Plans
There are federal government issued retirement plans that also do not adhere to ERISA laws, and thus a QDRO is not necessary to divide these plans. Government employees can obtain one of several retirement plans, the most popular being the Thrift Savings Plan (TSP). Other government retirement plans are the Federal Employees Retirement System (FERS) and the Civil Service Retirement System (CSRS). Each of these plans has their own unique rules for division, and their own unique terminology. Although they do not require a QDRO, a similar process is employed to divide these accounts. The pertinent details can be found at www.tsp.gov (for the TSP), www.opm.com (for the FERS and CSRS).
Because the TSP is the most common of these government plans, it is worth exploring the rules on dividing such accounts. While it is not necessary to obtain a QDRO for these accounts, it is necessary to obtain a “retirement benefits court order,” and there are several additional requirements that this order must meet:
- The order must be issued by a court in one of the 50 United States, or a United States territory.
- The order must be clear on it’s face that it relates to a TSP. This is achieved by referring to the plan as a “Thrift savings Plan.” Simply referring to the plan as a “government retirement plan” or “Federal retirement benefits” is insufficient.
- The order must be clear regarding the dollar amount, fraction or percentage that the payee is entitled to.
- The order can only require payment to the employee’s current or former spouse or the employee’s dependents.
If these four requirements have been met, there is a four-step process that the TSP plan administrator will employ to process the order.
First, the account will be frozen. Next, the order will be reviewed to ensure that it is complete, and that the four requirements have been met. Should the order be deemed incomplete, the parties will have 30 days to complete it otherwise the account will be unfrozen and no additional action will be taken. Next, the TSP will determine how the account should be divided, and finally the TSP will submit a decision letter to all parties who have an interest in the action. This letter will specifically discuss the effect the order has on the plan, how long the account will be frozen, the amount that will be disbursed, and the length of time it will take for the amount to be paid.
If a spouse was a state government employee, as opposed to a federal government employee, a QDRO can be used to divide the account. This is true despite the fact that state employee plans are not governed by ERISA.
Update Beneficiary Designations
One final bit of advice regarding retirement plans and divorce, is that the spouse who owns any retirement account after divorce will need to take action to update all designated beneficiary information. A divorce decree alone will not remove a spouse as beneficiary on a retirement account. Accordingly, updating a final will and testament also does not affect the beneficiary designations on retirement or other accounts. That being said, should a spouse wish that their former spouse not receive any benefits upon death, action must be taken. Most plans will let the account holder change the beneficiary fairly easily, while others may require that that person to prove a “life status change.” Simply offering a copy of a divorce decree, court order, or separation agreement can usually prove this change.
In sum, great care should be given when it comes to dividing retirement accounts incident to divorce. Not only is there complexity involved with determining what portion of a retirement account is marital and how to value retirement accounts, there are very specific rules that should be adhered to regarding disbursement in order to avoid experiencing an adverse tax consequence. Always consider these complexities and address them prior to your divorce being finalized otherwise you may not be left with any legal recourse.