In many divorces, a qualified retirement plan (such as a 401k) can be the largest asset for the spouses to divide. This is especially true when there isn’t a house at stake. While each employee should be familiar with the rules (or be able to talk with their plan administrator), this can be a big challenge for the non-employee spouse. In most cases, the spouse has had little or no knowledge of the qualified plan details, because that’s what the employee spouse usually did.
Because a divorce usually has so many competing priorities, it’s easy to make mistakes when it comes to dividing assets. When it comes to dividing a retirement plan, some of those mistakes can lead to paying unnecessary taxes (or penalties along with those taxes). With a little diligence, it is possible for both spouses to keep their fair share without Uncle Sam taking a cut.
With that in mind, here are 7 common mistakes that you might make when transferring your ex-spouse’s 401k into your own account, and how to avoid them.
1. Assuming the QDRO ‘tells the plan administrator what to do.’
In order to properly divide employer-sponsored retirement plan assets, the plan administrator will require a ‘qualified divorce relations order,’ or QDRO. A QDRO is a legal document that gives specific information to the plan administrator in order to properly divide the assets.
However, there are a couple of things everyone should know about a QDRO:
- No qualified plan can divide retirement benefits without a QDRO. This applies to any plan covered by the Employee Retirement Income Security Act (ERISA) of 1974.
- The judge does not draft the QDRO as part of the divorce. The divorcing attorneys should draft (or hire a specialist to help draft) the QDRO for the court to approve.
- The QDRO is not automatically included with divorce paperwork. This is a separate effort that you need to discuss with your attorney.
- The QDRO cannot make the plan administrator do anything that the plan doesn’t already allow. In fact, the plan administrator, following the plan’s procedures, has the authority (and responsibility) for determining whether a domestic relations order is actually qualified in the first place. In other words, if the court order tries to achieve something that’s not allowed in the plan, then the administrator can determine that the order is not ‘qualified.’ Which means it has to go back to the court to be rewritten in a manner that complies with the plan procedures.
How to avoid this mistake:
- Make the QDRO a priority in finalizing the divorce. As long as the marriage still exists, you have certain rights within the retirement plan. For example, any ERISA plan is required to make the spouse the default beneficiary in case the participant dies. However, all bets are off once the divorce is final. While it might not always be practical to have the QDRO finalized by the time the divorce papers are signed, you should at least be far along enough to see the finish line.
- Hold your lawyer accountable for drafting the QDRO. No one is responsible for drafting a QDRO, so don’t assume that it just gets done as part of the divorce process. Furthermore, most attorneys will agree that it is the non-employee spouse’s (or alternate payee’s, as the plan may call you) responsibility to ensure the QDRO is signed by the judge AND accepted by the 401k administrator. After all, you’re the one who loses out if no action is taken.
- Have the plan administrator review a draft version of the QDRO before it goes for signature. Not all plan administrators will do this. However, if your spouse’s plan does allow for this, you should have your lawyer send a draft copy to the administrator. That way, you can make any necessary adjustments before the judge signs off. Done correctly, this should help to minimize unnecessary re-writes.
- Familiarize yourself with all the employee benefits. While it’s important to understand what you might be entitled to under the plan itself, you should take the time to review ALL available employee benefits. You might find other available plans or benefits that you could be otherwise entitled to, such as a health savings account or a non-qualified plan.
2. Taking a taxable distribution when you don’t have to.
When it comes to moving money from a qualified retirement plan, that’s called a distribution. Distributions from a pre-tax retirement plan are taxable unless they qualify as an eligible rollover into a new retirement plan. You can do this in one of two ways:
- Direct rollover: This is a request to the plan administrator to directly transfer the funds into another retirement account. Some plan administrators will establish a separate account within the plan (pursuant to the QDRO), or they can directly transfer the money into a retirement plan (such as an IRA) that you’ve set up separately.
- 60-day rollover: If you don’t arrange for a direct rollover from the plan administrator, you will receive a check for the specified amount, minus taxes. The IRS requires that all retirement plan distributions (not including direct rollovers), be subject to a 20% withholding, even if you intend to roll it over later. Generally speaking, you have 60 days from the date you receive a distribution to roll it over into another plan or IRA. After 60 days, that money is considered to be taxable income, and subject to taxes (and possibly an early withdrawal penalty).
For people who are able to complete a direct rollover, there isn’t usually an issue. However, if you receive a check, and your intention is to put this money into your own IRA, there might a couple of reasons you inadvertently might run afoul of the 60-day rollover rule:
- You don’t have a QDRO on file, but you decide to pull the money out anyway. Under IRC §72(t)(2)(c), one of the exceptions to the early withdrawal penalty is if the money is paid to ‘an alternate payee under a QDRO.’ However, due to cash needs, you might be tempted to have your soon-to-be ex-spouse pull the money out (if possible), then send you the proceeds. In most cases, this probably will end up in a result that neither of you want. Yet another reason to make sure your QDRO gets done properly.
- You don’t replace the taxes withheld. When issuing a distribution to a non-retirement account, ERISA plan administrators are required to withhold 20% of the distribution and remit them to the IRS for tax purposes. This is true in all cases, even if you intend to put the money back into a retirement account in the future. The primary exception to this is when the plan administrator sends a distribution check to you, but it’s made out to the IRA or other retirement plan account. However, if taxes were withheld, you have to fund the new account with the entire gross distribution, including the withheld taxes. even if you use funds from another account. Otherwise, the distribution does not comply with the 60-day rollover rule.
For example, if you receive $50,000 from your ex-husband’s 401(k) in the form of a check made out to you, you should expect that check to be $40,000 ($50,000 minus 20%). Let’s say you plan to roll this over into a new IRA you set up. In order to qualify as a non-taxable event, you would need to deposit the $40,000 into your IRA, plus $10,000 to make up for the taxes that were withheld. Otherwise, it doesn’t count as a rollover.
Note: If you complete the rollover, you will eventually get the $10,000 back when you file your tax return, but that doesn’t help you now.
- You don’t have your IRA set up, so you have no place to deposit the check, and no place to tell the plan administrator to send the funds to. It should go without saying that if your intention is to have the plan administrator send funds directly to your IRA, then you need to have an IRA already established in the first place!
How to avoid this mistake:
Spell out exactly what you want in the QDRO. The QDRO should tell the plan administrator:
- How much money you want to transfer to another retirement account.
- Which account that money will transfer to (either an account set up for you as the alternate payee, or to another retirement plan you’ve already established).
- How much money, if any, you want directly disbursed to you. This allows you to avoid any early withdrawal penalties (which might not apply if you’re age 59 ½ or older). You will, however, be subject to ordinary income tax on distributions from tax-deferred accounts.
- Arrange for a direct transfer or rollover. If possible, avoid having the money sent to you directly. As long as the money is kept out of your hands, the plan administrator does not have to withhold taxes, and does not have to report it as a taxable event to the IRS. If they insist on sending you a check, check with your financial institution to make sure you understand how the check should be made out. Usually, the check will be made payable to your new account, but you can avoid any hassles by verifying the exact verbiage that should be on the check.
- Open your own retirement account, if you don’t already have one. Even if it’s not funded, having your own IRA will help you avoid a pretty simple mistake.
3. Paying a penalty when you didn’t mean to.
As previously discussed, under IRC §72(t)(2)(c), one of the exceptions to the early withdrawal penalty is if the money is paid to ‘an alternate payee under a QDRO.’ If your intention is to use some of the proceeds to pay for living expenses or a purchase (like a car or house down payment), you might want to take a hard look at the available options.
But there might not be any, and this is your only choice. That’s okay. But while you should expect to pay taxes, you should NEVER pay a penalty, even if you’re under the age of 59 ½ (the magic age for people to withdraw money from a retirement plan without penalty). Here are some things you need to do to ensure that you don’t pay early withdrawal penalties (if you’re subject to them):
- Talk with a Certified Divorce Financial Analyst™ (CDFA) about your finances before finalizing your QDRO. A CDFA™ has specific training to help people with their financial planning needs during, and after a divorce. A CDFA™ will be able to help you ensure that you’re only taking out what is necessary, even if plans change.
- Be very clear in your QDRO about how much money is coming to you, and how much is going to a retirement account. In fact, since account balances can fluctuate, you should specify the exact dollar amount that goes directly to you, with the remainder going to the retirement plan (if the plan allows).
- Do not take more money that what is specified in the QDRO. Even if plans change.
4. Overlooking employer contributions.
When most people consider a defined contribution plan, they think about employee contributions. But depending on the plan, and how long your ex-spouse has been participating in that plan, there could be a substantial amount of employer contributions as well. It’s important not to overlook the employer contributions when dividing up the plan. But first, a little background:
Employee contributions to a defined contribution plan are always vested. This means that when they leave the company, employees can take the money from their plan that they put into it. Regardless of why they’re leaving the company. It’s their money, so they can move it.
Employer contributions are a little different. Employer contributions are either vested or non-vested. Vested employer contributions are portable, just like employee contributions are. Non-vested employer contributions are not portable. While the account balance usually reflects both vested & non-vested employer contributions, non-vested contributions usually disappear if the employee leaves the company.
Here’s why this matters: when you’re dividing retirement plan assets, you need to ensure that vested employer contributions are included. If your soon-to-be ex-spouse is entitled to those assets, then you’re entitled to your fair share. Here’s how you can make sure this happens:
- Ensure the financial affidavit and supporting documentation includes ALL employer contributions. If you’re not sure that it does, ask for the most recent statement, which should break down the account balance, as well as employee & employer contributions.
- Ensure that the equitable distribution worksheet includes ALL employee AND vested employer contributions.
- If there is a significant amount of non-vested contributions at stake, have a discussion with your lawyer. This is where things get sticky. Depending on which state you’re in, and what type of plan you’re discussing, there is no easy way to determine where this will go. While many states recognize non-vested contributions, you’ll want to have an in depth discussion on how this might play out.
5. Not understanding the difference between Roth and non-Roth accounts.
One of the biggest tax mistakes you can make, in any divorce situation, is assuming that all retirement plans have the same tax treatment. When comparing a $100,000 traditional IRA to a $100,000 Roth IRA, you should understand that qualified distributions from a traditional IRA will always be taxed, because the contributions were tax-deductible (or pre-tax contributions). Qualified distributions from a Roth IRA are not taxed, because the contributions were made with after-tax dollars.
So let’s assume that you have a $100,000 traditional IRA and your soon-to-be ex-spouse has a $100,000 Roth IRA. Since they are individual accounts, it might be easier to just declare your account to be yours, and his account to be his. However, let’s look at the after-tax value of these accounts, not including investment returns. Assuming that you’re in the 22% tax bracket, over time, $100,000 in your traditional IRA would only yield $78,000. At the same time, your ex-spouse would be able to pull $100,000 out of his Roth account tax-free (assuming that his withdrawals are qualified distributions).
Since the tax treatment of a Roth IRA and a Roth 401(k) are the same, the same principle applies to dividing 401(k) plans, or when trying to divide multiple 401(k) plans AND IRAs. The best way to avoid this mistake is to ensure you know which accounts are Roth accounts (tax free qualified distributions), and traditional retirement accounts (taxable qualified distributions).
6. Not accounting for company stock
Many employer-sponsored retirement plans offer the opportunities for employees to purchase stock. If this is the case in your spouse’s situation, you should understand that there could be tax planning opportunities regarding the company stock within the plan.
Detailing the intricacies of this tax treatment (known as net unrealized appreciation) is outside the scope of this article. However, you should consult with a financial professional, like an accountant or a Certified Divorce Financial Analyst (CDFA®) so you can better understand what your options are.
7. Exposing assets to creditors unnecessarily
If creditors might be coming after you, then you’ll need to plan accordingly. ERISA protects most employer plans, like 401(k) plans, from creditors. This includes bankruptcy and non-bankruptcy situations. However, once those assets move from a 401(k) plan to a non-ERISA plan, like an IRA, the rules change. In this case, those assets would be protected under federal law in a bankruptcy case (as long as the money originally came from an ERISA plan). However, in a non-bankruptcy case, state rules might apply instead.
If either bankruptcy or creditor action appear to be on the horizon, you’ll want to discuss your options with your attorney, or a bankruptcy attorney licensed to practice in your state.
Divorce is a difficult and emotionally taxing process. During that time, you and your ex-spouse might make well-intentioned decisions that end disastrously. When dividing your retirement plans, it’s particularly important to pay attention to the details.
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.