Divorcing couples can face enough agony as it is dividing up possessions and agreeing on custody of children, let alone splitting retirement assets.
Yet that nest egg often represents a divorcing couple's largest pot of money. And if the process for the division of those assets is not done properly, there can be a steep price to pay in taxes, penalties or an unintended amount of money going to an ex-spouse.
Even if you have an attorney — whether for a courtroom battle or mediation — experts say it's important for splitting couples to understand what's at stake.
"You are own best advocate in divorce," said certified financial planner Ann Zuraw, president of Zuraw Financial Advisors in Greensboro, North Carolina. "You might think your lawyer won't [miss anything], but you should really know as much as you can to make sure everything gets covered."
Dividing 401(k)s and similar accounts ranks high on the list of things commonly fought about in divorce, according to a 2016 American Academy of Matrimonial Lawyers survey of its members. The top three contentious items are alimony (83 percent), retirement accounts and pensions (62 percent) and business interests (60 percent.)
(It's worth noting that for divorces executed after 2018, alimony will no longer be a tax deduction for the paying spouse and will not be taxable income for the recipient. While the change is expected to make divorce messier, experts say it should have a minimal impact on the division of retirement assets.)
The type of retirement account being split up determines the process for making that division happen smoothly.
If your soon-to-be ex has a workplace retirement plan and you are entitled to a piece, the only way to legally access your share is through what's called a qualified domestic relations order, or QDRO. This is the case whether it's a 401(k) plan or traditional pension plan.
A QDRO is separate from a divorce agreement, although it is based on the contents of that decree. Because these court orders are a specialized legal area, make sure the attorney who drafts it has some expertise.
Ideally, that lawyer — who may or may not be your divorce attorney — will contact the plan's administrator to ensure the required steps are taken for a smooth transfer of your share of 401(k) funds or pension plan benefits (whether immediate or future).
Before this document is submitted to the court, you and your divorce attorney should review it to ensure the intent of the divorce agreement is reflected in the QDRO. If more than one retirement account is getting split, a separate order is required for each one.
"If none of that review occurs and the [QDRO] happens in a vacuum, mistakes can happen," said certified financial planner Lili Vasileff, founder and president of Divorce and Money Matters in Greenwich, Connecticut.
If 401(k) funds are getting transferred to a rollover IRA, the QDRO needs to spell that out. This so-called trustee-to-trustee transfer is not a taxable event for either the 401(k) account holder or the recipient.
However, some ex-spouses choose to receive the money directly instead of transferring it to a rollover IRA. While divorce is one of the few times that 401(k) funds can be accessed before age 59½ without incurring an early withdrawal penalty of 10 percent, the recipient would pay ordinary income taxes on the money. This type of distribution must be specified in the QDRO.
Although experts generally agree that retirement money should be off-limits for anything but funding your golden years, an individual's financial circumstances sometimes necessitates the distribution in divorce, Zuraw said.
Once the QDRO is in place, your 401(k) plan administrator must approve it and then the transfer will take place.
For the recipient of the 401(k) funds, it's important that you do not agree to a change of beneficiary before the divorce is final. As long as you remain married, account owners cannot name anyone other than a spouse without your approval, Zuraw said.
The reason this matters is that if your soon-to-be ex passes away before the divorce is final, you might no longer have any rights to the 401(k).
Additionally, make sure that if the intent is for each spouse to get, say, 50 percent of the 401(k) assets, the divorce decree and QDRO state that percentage instead of a fixed amount.
Here's why: Say there's $100,000 in the 401(k) and the non-account-owner is to receive 50 percent. If the QDRO states the receiving spouse should get $50,000 — which represented 50 percent at the time it was written — and the account posts gains or losses before the transfer is made, $50,000 no longer represents 50 percent.
Also, be aware that if you are headed for bankruptcy, assets in 401(k)s are protected in that process, while IRAs are fair game for creditors. If this is your situation, consider leaving your share in the 401(k) plan (in your own account, of course).
While a QDRO is not required to split up assets in an IRA (traditional or Roth), you still need to make sure the split is done properly so no tax or penalties are incurred.
The divorce decree itself must specify the division, including the amount and when it is to occur. The custodian of the IRA — i.e., a bank, brokerage or other financial services company — will need a copy of the agreement and require paperwork to be filled out. There also should be a rollover IRA account ready to receive the funds.
"Generally speaking, it's a straightforward thing to do," Vasileff said.
However, she said, just because a QDRO isn't needed, it doesn't mean that IRA owners can take matters into their own hands. If funds in a traditional IRA are withdrawn and then given to the ex-spouse — i.e., it is not a trustee-to-trustee transfer — it is considered a taxable event for the IRA's original owner.
Not only would that person potentially owe regular income taxes on the money, a 10 percent early withdrawal penalty could be due if they're under age 59½ (the age when you can begin withdrawing from a traditional IRA without incurring that penalty, with few exceptions).
While Roth IRA withdrawals are treated differently because the contributions have already been taxed, it's still important to do a trustee-to-trustee transfer. The Roth owner could face taxation or penalties upon withdrawal depending on their age and how long they've owned the Roth IRA.