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The financial implications of a divorce can certainly be complex to understand, and figuring out what happens to your retirement funds is no exception.
First, it's important to note that retirement earnings accrued during a marriage generally qualify as marital assets that can be divided in a divorce. The key here is three little words — during a marriage — as retirement savings are considered marital property to the extent that the funds were earned while the marriage took place. Premarital retirement savings are considered separate property.
Your state of residency plays a major role in how retirement accounts are handled during a divorce. Depending on where you live, retirement accounts like 401(k)s or IRAs might be deemed community property or equitable distribution.
In community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin — any assets acquired by either spouse during the marriage are considered to be owned jointly, regardless of who buys the asset. This means financial resources accumulated during the marriage, such as retirement funds, are divided equally, explains Brooke Hunady, certified financial planner and partner at Moneta Group.
In all other states that follow equitable distribution rules, the state's courts will divide marital property in an equitable manner that is fair but not necessarily equal, Hunady adds, meaning 401(k) or IRA earnings accrued during the course of a marriage may not be split 50/50.
Below, Hunady helps us see how dividing up retirement accounts in a divorce would play out.
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For this example, let's assume an equal division of assets — which would occur in a community property state — since equitable distribution is up to the court to decide.
With a traditional 401(k) account, a judge would order these funds, which were accrued during marriage, to be split through what's called a Qualified Domestic Relations Order. "One spouse may have a 401(k) where the other does not, therefore half of the 401(k) will be distributed to the other spouse," Hunady says.
The receiving spouse can then put the 401(k) proceeds into a retirement account in their name or take the distribution outright. "Be aware that if an outright distribution is taken, you will be subject to ordinary income taxes," Hunady warns.
Similarly, with a traditional IRA, half of the funds accrued during marriage would be transferred into an IRA for the other spouse's benefit. Big-name brokers such as Charles Schwab, Fidelity and Vanguard all offer IRAs that make signing up a quick and easy process. Note again that any withdrawal from the traditional IRA — excluding the initial transfer from one spouse's IRA to the other — would result in ordinary income tax, and could also be subject to early withdrawal penalties if your spouse is not yet 59½ years of age.
While an even split of a retirement account may be easiest, Hunady points out that may not always be the best solution and you should always weigh the tax implications of the proposed asset division.
"For example, a $50,000 traditional IRA cannot be viewed the same as $50,000 in cash, as you will owe tax on the traditional IRA assets at some point in the future," Hunady says. "The funds residing in the IRA will continue to grow tax deferred until withdrawn, so working with your tax and financial advisor to better understand how the division of assets will impact your financial wellbeing is key."
What happens when both spouses have 401(k) plans and/or IRAs
In this case, Hunady indicates it is possible to maintain your respective retirement accounts, however if one account value is higher than the other, the Qualified Domestic Relations Order or transfer to the other spouse could come into play. Or, if other financial assets exist, it's possible to maintain your respective accounts and utilize these other assets to equalize the division, she says. Again, take into account any tax implications that may exist.
Last but not least, part of managing retirement accounts following a divorce is updating your beneficiaries, or the recipients of any transferred assets. Hunady gives the example of an account owner who passes and their beneficiary is an ex-spouse who then claims the assets at the owner's death.
"It can be very difficult for the rightful beneficiary to recoup those assets, therefore updating beneficiaries immediately following a divorce is highly recommended," Hunady says.
There are certainly many moving pieces in a divorce, but figuring out how your retirement funds will be affected is crucial given you're relying on this money in your nonworking years.
Start by knowing whether your state of residency is classified as a community property or equitable distribution state. From there, you'll know what to expect when it comes to any retirement earnings that were accrued during your marriage. During this time, Hunady suggests that collaboration among your team of advisors, including your attorney, financial advisor and accountant, is essential.