When dividing assets in a divorce, a common mistake people make is assuming that IRAs and 401k accounts are the same. While both are different types of retirement accounts, there are some key differences. Not accounting for those differences can have a huge financial impact. Here are six key differences between IRAs and 401ks that you should know.
You don’t need a QDRO to divide an IRA.
In order to access your ex-spouse’s 401k (or any qualified retirement plan, for that matter), you must give the plan administrator a qualified domestic relations order (known as a QDRO). A QDRO is a judgment, decree, or order that gives an ‘alternate payee’ the right to receive a portion or all of the benefits of a retirement plan. An alternate payee can either be the ex-spouse or other dependent of the retirement plan participant, such as a child.
A QDRO is drafted by the involved attorneys (usually the attorney representing the alternate payee spouse) and submitted to the appropriate jurisdiction (such as a court), then issued, either as part of the divorce decree, or as a separate order. Then, it is sent to the retirement plan administrator, who has specific duties and responsibilities to determine whether the order actually ‘qualifies’ or whether it needs to be amended.
Needless to say, there are a lot of variables here, and a lot of ways this process can go awry. A good QDRO attorney can identify, and help you avoid these pitfalls when dividing a 401k.
However, none of this applies to an IRA. The IRA custodian needs only the copy of the divorce decree, which should clearly define how the IRA should be divided. The best way to do this is via a direct trustee-to-trustee transfer in the name of the former spouse.
For example, let’s imagine Kevin and Anne are getting a divorce. Anne is to receive 50% of Kevin’s IRA, currently valued at $100,000. The divorce decree should clearly state how much Anne is to receive. The best thing for Anne to do would be to present a copy of the divorce decree to the custodian and ask for her share to be transferred to an IRA account in her name. If she does not already have an IRA, the custodian should be able to establish an account for her. In this case, Anne’s IRA would receive a direct transfer of $50,000. Done correctly, this should not be a taxable event.
In other words, dividing an IRA can be much simpler than dividing a 401k. However, there are some limitations, particularly if you need to generate cash.
The 10% early withdrawal penalty doesn’t apply to a 401k withdrawal—pursuant to a QDRO.
Before we go too far, let’s discuss the 10% early withdrawal penalty for IRAs and 401k plans. Generally speaking, for withdrawals from a retirement plan before age 59 ½, the IRS imposes a 10% early withdrawal penalty, in addition to the taxes that would apply. There are exceptions, such as if the owner dies or becomes permanently disabled.
One of those exceptions, outlined under Internal Revenue Code 72(t)(2)(C), is payments to alternate payees pursuant to a qualified domestic relations order. However, it’s clear that this exception only applies to qualified retirement plans. An IRA is not a qualified plan.
Not being a qualified plan is what allows you to divide an IRA without a QDRO. However, that also means that this exception does not apply to IRA assets.
Using the above example, let’s imagine that Anne needs $10,000 in cash. She and Kevin are both 45, so they would be subject to the IRS’ 10% penalty for early withdrawal. If Anne takes $10,000 from her share of the IRA, she would owe taxes on the withdrawal (at her ordinary income tax rate), plus $1,000 (10% of the $10,000 withdrawal).
Let’s assume that Kevin also has $100,000 in a 401k at work. If Anne were to have a QDRO drafted as part of the divorce settlement, she could have the QDRO state that $10,000 be distributed directly to her. She would still pay the same taxes on the 401k withdrawal as she would on the IRA withdrawal. However, she would avoid paying the $1,000 that she would be subject to under IRA rules.
This assumes that the withdrawal is pursuant to a QDRO. This is important, since this can trip you up. If you have emergent cash needs, and the QDRO is taking too long, you might be tempted to take a short cut. You would probably be better off trying to find another source of cash than to do this.
A 401k may contain unvested employer contributions.
One of the most attractive parts of an employer-sponsored retirement plan is that in many cases, the employer can match employee contributions. This provides an incentive for people to start saving in the first place. If your employer matches your 3% contribution dollar for dollar, that’s 100% return on your money, before any investment results! After all, who doesn’t like free money?
There’s a catch. In most plans, there’s a vesting schedule. In other words, the employee has to stay with the company for a certain period of time before the employer’s contributions vest, or permanently become a part of the employee’s retirement plan. If the employee leaves before the employer’s contributions vest, then they forfeit those contributions. Keep in mind, this only applies to employer contributions—employee contributions are always 100% vested, from day one.
In order to be a qualified plan, a 401(k) has to offer a vesting schedule that is no more restrictive than either of the following:
6-year graded vesting. This means that an employer can ‘vest’ contributions gradually over a 6 year period.
3-year cliff. An employer can choose to not vest for the first 2 years, then vest 100% of the employer contributions at the end of the third year.
So what do you need to know? Well, if you or your spouse haven’t been working long enough to be fully vested in the company retirement plan, then you need to take this into account. Specifically, you’ll want to ensure that your QDRO (since you’ll need one) addresses what happens to unvested employer contributions.
Depending on your circumstances and applicable state laws, there is a wide range of things that could happen. However, you’ll want your lawyer to stay on top of this to ensure that what does happen is a desirable outcome.
With an IRA, none of this applies. Since you (or your spouse) presumably made all of the IRA contributions, there are no restrictions on how you can choose to divide them.
Tax withholdings are different.
By law, a 401(k) plan must withhold 20% of any distribution made payable to the plan participant. This occurs for every single 401(k) distribution that is not directly transferred to another eligible plan or to an IRA. If the distribution is made directly to an eligible plan or an IRA, no taxes are withheld.
Conversely, the default withholding for an IRA distribution is 10%. However, you can elect out of withholding or choose to have a different amount withheld, according to the IRS.
Different creditor protection laws apply.
Qualified plans, such as 401(k) plans, are protected from creditors by the Employee Retirement Income Security Act of 1974 (ERISA). There generally is no limit to the amount you can have protected in a 401(k) plan. Also, 401(k) plans are protected in bankruptcy and non-bankruptcy cases, with two exceptions:
IRS. While the IRS may choose to go after other assets first, retirement plan assets are not off limits.
Not only are funds in a 401(k) plan protected, they’re also protected in bankruptcy cases if you roll them over to an IRA, again without limit. However, this does not apply to solo 401(k) assets.
Conversely, IRAs are protected in bankruptcy cases by a federal law called the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) but with a dollar limit. As of this writing, that limit was $1,283,025, but is expected to be adjusted upward in the near future. However, there are some additional limitations:
IRAs do not have federal protection in non-bankruptcy cases.
Inherited IRAs have no federal bankruptcy protection
By all means, this is not a comprehensive list of the differences in creditor protection. However, if you expect to deal with creditors and/or file bankruptcy in conjunction with your divorce, you will want to discuss your concerns with your lawyer or with a bankruptcy attorney. That way, you’ll be able to take these factors into consideration as part of your equitable distribution.
You don’t always have to start taking distributions from a 401(k) at age 70 ½.
30 years ago, this was an unnecessary statement about divorce, because gray divorce did not even really exist. However, gray divorce has been on the rise in recent years, particularly for individuals aged 65 and older. Additionally, a recent AARP study shows that more people are working past retirement. In light of these two trends, it’s important to discuss that dreaded three-letter acronym: RMD (or required minimum distribution).
Both 401(k) plans and traditional IRAs allow you to defer distributions for a limited time. Generally speaking, a taxpayer who reaches age 70 ½ has to start taking distributions from either plan each year for the rest of their life. After that age, a taxpayer must calculate their RMD using an IRS worksheet, called an “IRA Required Minimum Distribution Worksheet.” Despite the name, the same worksheet is used for IRAs and 401ks. But the rules are slightly different.
For IRAs: Since there are different types of IRAs, there are slightly different rules.
Traditional IRAs: Generally speaking, distributions from a traditional IRA must by April 1 of the year after you turn age 70 ½. No exceptions.
Roth IRAs: Roth IRAs have no RMDs.
Inherited IRAs: Whether an inherited IRA was a traditional account or Roth, RMD rules do apply (tax treatment depends on the type of account). However, different rules may apply, depending on:
Whether the IRA owner died on or after the date they were supposed to take distributions
Whether the beneficiary was the spouse or a non-spouse beneficiary
For 401k plans: Generally speaking, distributions must begin by either:
April 1 of the year after you turn 70 ½, just like an IRA
April 1 of the year after you retire.
In other words, if you are a 401(k) plan participant, and never retire, you never have to take RMDs, and you never have to pay taxes on anything. When you eventually pass away, your beneficiaries would eventually start taking RMDs based upon inherited qualified plan rules. However, you do not.
These differences offer unique tax planning opportunities for those who wish to defer taxes, but do not plan to stop working in their retirement years.
By no means is this an all-inclusive list of differences between IRAs and 401(k) plans. However, by acknowledging these differences between the two, you can better determine how to divide assets in an equitable manner that is also more tax-efficient.
And if you’re ready to take the next step and work with a financial planner, you can learn more about how we work with clients right here.