Divorce and retirement can be a very touchy subject. How do you split retirement plans during a divorce? If you are going through divorce, you will likely need to share assets in your retirement plans. It’s crucial to handle this properly and ensure that the right party is responsible for paying applicable taxes and following the correct rules.
QDRO vs Transfer Incident to Divorce
A separate legal term applies to each type of division for IRAs and qualified plans, even if they are divided in the same way. A Qualified Domestic Relations Order encompasses qualified plans like 401(k)s and 403(b) plans. IRAs are divided using a process known as a Transfer Incident to Divorce.
In many courts, both types may be labeled as QDROs, but you and your spouse should clearly note the category in which each of your retirement assets falls when the information is submitted to the judge or mediator. This ensures that assets are listed correctly in divorce agreements and avoids unnecessary complications.
Dividing a Qualified Plan
Qualified plans have protection from seizure or attachment by creditors and lawsuits, but divorce is one of the few exceptions. Divorce and separation decrees allow the attachment of qualified plan assets by the ex-spouse of the plan owner if the spouse uses a QDRO. This decree divides the plan assets between the owner and their current or ex-spouse, or children or other dependents.
This is a tax-free transaction if it is reported correctly to the courts and the IRA custodians. The receiving spouse can roll QDRO assets into their own qualified plan or into a traditional or Roth IRA.
No tax will be assessed on the separation transaction of an IRA division if it is specified as a transfer incident to divorce in your agreement. Depending on the circumstances, the IRA custodian may classify the movement of funds as a transfer or a rollover.
The recipient will take legal ownership of the assets when the transfer is complete and assume total responsibility for the tax consequences of future transactions. You will not be responsible for taxes on the assets sent to your ex-spouse.
Early Withdrawal Penalty
Unfortunately, if you fail to adequately label your division, you will owe tax and an early withdrawal penalty on the entire amount that your ex-spouse received. To avoid this, you will need to clearly list both the division percentage breakdown and the dollar amount of IRA assets being transferred, as well as the sending and receiving account numbers for all the IRAs involved in the transfer.
This information must satisfy the sending and receiving IRA custodians, the judge and state laws. This is one reason why we highly recommend hiring a financial professional to assist in the splitting of retirement accounts. It is incredibly helpful and well worth the money. If the division agreement is not approved by the courts, the IRS will require an amended tax return reporting the entire amount you sent to your ex as ordinary income. Furthermore, the amount your ex-spouse received is not considered an eligible transfer and therefore cannot be placed in an IRA. Tax deferral benefits will be lost, and you may be responsible for compensating the loss.
Updating Beneficiary Designations
After you send or receive your IRA or qualified plan assets, update your beneficiary designations to reflect the changes. You should also update your beneficiaries on other financial assets like life insurance and annuities.
Handling Divorce and Retirement in Northern Virginia
Having the courts and IRA and/or qualified plan custodians recognize your divisions as QDROs or transfers incident to divorce is crucial. This eliminates tax consequences for you and your ex-spouse. However, lack of attention to detail can complicate the divorce process and have expensive consequences. The professionals at Argent Bridge Advisors can help you navigate this process. Contact us today to learn more.