The dissolution of a marriage is often a very stressful and challenging process, and decisions on dividing retirement assets can often exacerbate things, as this nest egg usually represents the couple’s largest resource base. And making mistakes when splitting these accounts can result in taxes, penalties and, potentially, an unintended portion of the money going to the ex-spouse.

Dividing qualified plan accounts – like 401(k)s, 403(b)s, and profit sharing plans – is one of the top sources of disagreement in divorce, together with alimony and business interests. It’s important to note that after 2018, alimony will no longer be tax deductible for the paying spouse, and will not be taxable as income for the receiving spouse.

The process for ensuring a proper, smooth division of a retirement account depends on the type of account.

Employer-sponsored retirement plans
If you are entitled to a share of your ex-spouse’s retirement plan at work, the proper method for receiving your interest is through what is known as a “qualified domestic relations order”, or QDRO. QDROs are used for 401(k) plans as well as traditional defined benefit pension plans.

While a QDRO is separate from your divorce decree, it is based on the contents of that agreement. Because these court orders are a specialized, niche area of law, it is important to make sure that the attorney who drafts the QDRO is experienced in this field.

That attorney, who may not be your primary lawyer for your divorce, will contact the retirement plan’s administrator to ensure that the appropriate steps are followed to complete a transfer of your share of retirement account assets or pension benefits.

Before the QDRO is submitted to the court, you and your primary divorce lawyer should review it carefully, to make sure that it reflects the intent of the marriage settlement agreement. If more than one retirement account will be split, a separate QDRO is required for each.

If, for example, 401(k), 403(b) or profit sharing plan assets will be transferred to your Rollover IRA, the QDRO should detail this. Such a transfer – termed a “trustee-to-trustee” transfer – is not a taxable event for either the account owner or the recipient.

Occasionally, a divorced spouse will elect to receive the funds from the ex-spouse’s retirement account directly, rather than have them transferred to an IRA. While a divorce-related distribution is one of the few scenarios under which a recipient younger than age 59 ½ can avoid the IRS’s 10 percent early withdrawal penalty, income tax would still be owed on the money withdrawn. This type of distribution should also be detailed in the QDRO.

Once the QDRO has been drafted and submitted, the plan administrator must approve it, and then the transfer can be completed.

Individual retirement accounts
A QDRO is not required to divide assets in a traditional pre-tax IRA or post-tax Roth IRA. However, it’s still crucial to ensure that any split is done correctly, to avoid unnecessary taxes or penalties.

The marriage settlement agreement must detail the split, including the amount and the date when it is to occur. The account custodian – a brokerage firm, bank, credit union or other financial services company – will require a copy of the divorce decree, and will have paperwork to be completed. The recipient spouse should open a rollover IRA to receive their share of the divided funds.

While dividing an IRA is relatively straight-forward, and no QDRO is needed, it doesn’t mean that there are no potential pitfalls. If funds in a traditional pre-tax IRA are withdrawn and given to the ex-spouse (i.e. not via a trustee-to-trustee transfer), it is considered a taxable event for the IRA account owner. The owner could owe income tax on the money withdrawn, as well as a 10 percent early withdrawal penalty if they’re under age 59 ½.

While Roth IRA withdrawals are treated differently, because the account contributions were made with after-tax dollars, it’s still better to make use of a trustee-to-trustee transfer. The Roth IRA account owner could still face taxes or penalties on withdrawal, depending their age and how long they’ve owned the account.

As you can see, dividing retirement accounts can be complicated, and mistakes can be expensive. If you’re getting divorced, you may wish to have your accountant and financial advisor work with you and your attorney, to make sure that potential pitfalls are avoided.

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