Who Gets Custody Of The Retirement Funds During A Divorce?

Like the car wreck you don’t want to look at, yet can’t turn away from--they are shocking, yet strangely intriguing.  No, I’m not talking about the leaked Ashley Madison hack list. I’m referring to the disturbing stories of financial burden imposed on those who have incorrectly distributed funds from a retirement fund due to a divorce.

Whether you’ve experienced it first hand, or been an innocent victim injured by verbal shrapnel, divorce can be a devastating event for any family. Not only can it fracture delicate relationships, it can also be financially debilitating for all of those involved. This is especially true if delicate care isn’t taken when it comes to the division of retirement assets.

Your retirement accounts

When an employee changes jobs, the 401k or retirement plan they have from a previous employer can either stays where it is, or be moved elsewhere. After a few career changes, and just as many retirement plans floating around, the desire to consolidate the accounts into one is often requested. This can be accomplished by rolling the funds into an individual retirement account (IRA). Often this is how one may end up owning an IRA with a fairly sizable balance.

During a divorce, all qualifying assets typically get dumped into a huge proverbial bucket. This includes all jointly owned property, along with each person’s retirement accounts. That bucket then gets placed in the middle of an imaginary teeter-totter. Each party takes a turn removing desired items from the bucket, attempting not to tip the teeter-totter too much in any one direction, until all of the items have been eliminated, except the retirement accounts. Well, this is how it’s supposed to work anyway…

Distributing funds from a 401k per a divorce order

For retirement accounts, like employee benefit plans or 401k types of plans, something called a Qualified Domestic Relations Order (QDRO) is drawn up. This is a legal order assigning a portion of the rights of an existing benefit plan to an alternate payee. Basically it says this person has the right to X% of so-and-so’s 401k.

A QDRO only works on private sector plans though, meaning only those subject to the Employee Retirement Income Security Act (ERISA) guidelines. Military, civil service, and state retirement plans aren’t included, however, these types of plans are not untouchable, as they do have their own similar types of orders.

More often than not, a dedicated plan administrator will oversee these retirement plans, and ensure the order is being followed to the “T”, and that ERISA regulations are not being neglected. In essence, someone is making sure nothing gets “screwed upped” due to the enormous penalties and taxes that can be imposed for early or incorrectly titled withdrawals.

Distributing funds from an IRA per a divorce order

IRA accounts work a little differently. The IRS has ruled that distributions of an IRA, in the event of a divorce, and per a court order, are not treated like regular run of the mill distributions. And since IRAs don’t fall under the ERISA guidelines, a QDRO is not required. Instead the divorce decree can simply state that ‘Spouse A’ needs to give ‘Spouse B’ this many number of dollars from ‘Spouse A’s’ IRA account. Sounds simple enough, right? Let’s take look…

Example: John (age 50) and Jane (also age 50) have decided to get a divorce. In the divorce decree John is ordered to pay Jane $50,000 of his $100,000 total valued IRA. John goes to the bank, provides a copy of the court order to the bank employee, and requests an IRA withdrawal in the amount of $50,000 with the check made payable to Jane. So what’s wrong with this example?

First, John will be shocked come tax time to discover he very well may be hit with a 10% early withdrawal penalty, and have to pay taxes on the full $50,000. Why?

Why Trustee-to-Trustee transfers are important

John should have requested the bank do a trustee-to-trustee transfer, which is a transfer made directly between the financial institutions. If this option wasn’t available, making a check payable to the receiving financial institution for the benefit of (FBO) Jane would have also worked. Instead, he completed a “distribution” instead of a “transfer”, leaving him on the hook for the whole tab.

Next, Jane may not be eligible to roll those funds into her IRA any longer either, leaving her nest egg a little smaller than expected. The trustee-to-trustee transfer would have allowed her to do this, but not the traditional distribution option that John so unintentionally completed.

   

Another area of concern is being a little too quick on the draw… Even though all of the details of a divorce may have been agreed upon, until you have the final decree in hand, hold off on transferring any type of funds. If you transfer funds prior to the finalization of the divorce, you too could be liable for the early withdrawal penalty and taxes.

How to avoid the mishaps of confusion

So how can you avoid all of this mind-blowing confusion? Well, there are a few ways:

1. Don’t get married; or
2. Don’t get divorced; or
3. Have the exact same amount of money in each of your retirement accounts, that way neither will mess with the other person’s account and none of this will be an issue; or
4. Diligently follow the process of the distribution(s) to ensure the correct coding is used, amounts are distributed, payees are listed, and payment methods are utilized; or
5. Get advice from someone that knows what to do in this type of situation. The couple hundred dollars it may cost you up front may save you thousands in the long run; or
6. If dealing with an IRA situation, have the recipient open an account at the same firm. The process will be much easier, and less chance of error to occur; or
7. Hire someone to handle the transfer for you. If you haven’t consolidated those various 401k accounts into one yet, now is the perfect time.

Divorces are a tough thing. Starting over is scary. Just don’t begin that new journey in life with a huge tax bill, and don’t make starting over in your retirement account any harder than it needs to be. You’ll have plenty of other hurdles to clear along the way~

Want to see more ideas about saving money? Check out my other posts on Fix Our Budget, and follow me on Facebook.

Photo by Stuart Miles. Published on 18 March 2014
Stock photo - Image ID: 100249189