What happens to a 401k and other retirement assets in a divorce?
How Are Retirement Assets Divided in a Divorce?
Questions answered in this article:
Can I hide my 401k from my spouse during a divorce? | Should I cash out my 401k before my divorce? | Does your spouse always get half of your retirement accounts?
Retirement assets can be among the most valuable and complex assets to divide in a divorce. With the right attorney, and sometimes with the assistance of a financial advisor or pension valuator, you and your spouse can keep your futures secure.
Factors that Impact Division of Retirement Assets in a Divorce
There is a presumption in family court that retirement accounts should be divided equally—regardless of which spouse owns them or earned them. However, the court can order an unequal division of assets after considering a number of factors which include:
- The length of the marriage
- The property each party brought to the marriage
- The contributions of each party to the marriage
- The age and health of the parties
- The earning capacity of each party
In total, there are 13 factors the court must consider—and the court has broad discretion to give each factor whatever weight or importance he or she deems appropriate.
Keep in mind, the court’s goal is usually to divide the marital estate equally—not to divide each individual asset or piece of property down the middle. Especially when it comes to retirement accounts, there can be financial disincentives to cashing them out or dividing them. The court will look at all the pros and cons and will consider the best way to divide the assets. For example, if the parties have a retirement asset worth $100,000 and a home with equity valued at $100,000, the court might decide it is more convenient to the parties to simply award one party the retirement account and the other party the house. This way, both parties end up with equal value and it is cheaper and more efficient than having to cash-out or transfer a retirement account and also having to sell the house to free-up the equity for division.
Dividing Different Types of Retirement Assets
Parties to a divorce typically have one or more of the following kinds of retirement assets:
- Roth IRA
Pensions are a form of defined benefit plan that offers guaranteed retirement benefits to employees. Pensions are largely funded by employers with payouts based on a set formula that considers an employee’s salary, age, and tenure with the employer. However, some pensions allow employees to additionally contribute a portion of their incomes to the pension.
And while pensions are intended to provide a guaranteed income stream upon retirement, the pensions are often not “vested” (or fully owned by the employee) until the employee has worked at the business for a specified number of years or fulfilled other terms established by the pension plan.
Because pensions represent a future income stream (usually calculated as monthly payments), the value of that income stream may be speculative or unknown as of the date of divorce—which is when the family court is obligated to value all assets. In order to determine the present value of a pension interest, the court may order that the pension be evaluated by a professional pension valuator—a specialized accountant—so that only the existing value of the pension is included in the property division.
If the court determines that the parties should actually divide the pension—that is, that the pension account itself should be divided versus simply awarding the value to one party and offsetting it with other assets of equal value—it will issue a Qualified Domestic Relations Order.
A Qualified Domestic Relations Order (QDRO) is a special court order that is required to divide a pension into separate accounts for each party. This will give both spouses the ability to receive a portion of the monthly income stream generated by the pension in the future.
Click HERE for more information about how QDROs are processed and paid for during a divorce.
An IRA is an “Individual Retirement Account” that allows individuals to save for retirement with tax-free growth or on a tax-deferred basis. These accounts are typically offered by financial institutions and are funded by private individuals. They are not generally offered or financed by employers. There are several kinds of IRAs: Traditional IRAs, Roth IRAs, SEP IRAs, and Simple IRAs.
Unlike pensions and 401ks—which are funded with pre-tax dollars—IRAs are usually funded with after-tax dollars that are then allowed to grow in the account tax-free or be withdrawn tax-free in the future.
With a Roth IRA, the owner contributes after-tax dollars, the money grows tax-free, and the withdrawals are tax-free and penalty-free (if taken at retirement age). With a traditional IRA, the money is contributed either pre-tax or after-tax and the money is only taxed when it is withdrawn in the future.
IRAs can be easily valued in a divorce by looking at the balance on a current account statement.
If an IRA must be divided in a divorce, the parties can give the account administrator notice of their divorce (usually by providing a copy of their divorce judgment or the portion of it that specifies the IRA is to be divided) and the account administrator will establish a second account for the other spouse to hold his or her share. This transfer will be considered “incident to divorce” and will be tax-free and penalty-free. However, if the receiving spouse wants to use the money and desires to cash-out the account, he or she will be subject to the usual taxes and penalties on withdrawals.
A 401k plan is almost like a cross between a pension and an IRA. Like a pension, they are defined benefit plans offered by and contributed to by employers. Like an IRA, they are funded mostly by the individual employee—who is immediately “vested” in his own contributions.
Employer contributions may or may not vest immediately depending on the terms of the plan.
Contributions to a 401k are funded by pre-tax deductions from the employee’s paycheck. The money grows tax deferred and is only taxed upon withdrawal. Some 401ks offer ROTH options, which means that the contributions are taxed now, so that they can grow tax-free—meaning the withdrawals in the future will not be taxed.
Dividing a 401k in a divorce is also a bit like dividing a pension and a bit like dividing an IRA. Like pensions, the account can only be divided with a special court order called a Qualified Domestic Relations Order. But like IRAs, they can be easily valued by simply looking at the balance on a current account statement. As with an IRA, if the receiving spouse wants to cash-out the account, he or she will be liable for all taxes and penalties on their withdrawal.
When dividing retirement assets, the court is obligated to consider the tax implications to both parties. It is the “industry standard” in Wisconsin family courts, to discount the present value of retirement accounts (with the exception of ROTH IRAs) by 20 percent to account for the fact the parties will not enjoy the full value of the accounts because they will have to pay taxes on the money in order to utilize it. Twenty percent may be more or less than the actual taxes paid by a party on future withdrawals—but because the future is unknown, the court applies a 20 percent discount as a hedge against future tax liability in order to make a fair division at the time of divorce.
Pension Rights for Government & Military Spouses
Military and Government pensions are valued and divided no differently from pensions offered by private-sector employers. A court will establish the present value of the account, its future income stream, the vesting of benefits and the difficulty of dividing the account as established by the terms of the plan.
Military and Government sponsored retirement accounts are considered marital property and are divisible by the court under the normal property division statutes.
Can I hide my retirement account from my spouse during a divorce?
Short answer: No.
It would be very difficult to hide a retirement asset in a divorce. It is also illegal. Under Wisconsin law, parties to a divorce must disclose all assets and debts in which they have an interest—whether or not those assets are owned individually or jointly with others.
If your retirement accounts are offered through your employer, you are further obligated by federal law to name your spouse as the beneficiary of those accounts unless he or she signs a waiver allowing you to name someone else.
Therefore, your spouse should be well-aware of any retirement account that you own—if they are not aware because you hid the account or if you have secretly named an alternate beneficiary, it is like the court would consider your non-disclosure to be a violation of the law. The court could punish you by awarding the undisclosed asset to your spouse in a divorce.
Should I cash out my retirement account before my divorce?
Short answer: Probably not.
If you are younger than 59 ½ there are likely stiff penalties for cashing out your retirement account. You will also likely have to pay taxes on the withdrawals.
Also, any assets that are cashed out, transferred, or disposed of within one year of filing the divorce can be considered part of the marital estate. They can be offset or divided even if they no longer exist—especially when one spouse utilized the funds without the other parties’ knowledge or consent or if the person used the funds for non-marital purposes.
If you and your spouse agree that you should cash-out a retirement account before your divorce—perhaps to settle debts or subsidize your living expenses—you should only do so if you first consult with a tax professional and a divorce lawyer to ensure you understand the financial and legal consequences of your actions.
Does your spouse always get half of your retirement accounts?
Short answer: No.
As detailed above, the court has discretion how to divide retirement accounts. They can be divided directly—by literally separating the account into two accounts, or they can be divided in-kind, by trading the retirement account for an asset of similar value. Whether the court divides the retirement accounts 50/50 will be based on his or her analysis of all the factors a court must consider when dividing marital property.
Finally, if you have a retirement account that you received as a gift or that you inherited (or that you funded exclusively with gifted or inherited funds), it is possible the court will exclude the gifted or inherited account from division altogether.
Gifted and inherited assets are generally exempt from property division if they have maintained their gifted or inherited status and have not been co-mingled with martial property, contributed to the marriage, or substantially increased due to the efforts of the non-owning spouse.
To discuss your retirement accounts and how they might be divided in a divorce, do not hesitate to contact us for a free consultation!