In a Divorce, Who Gets the 401k?
A divorce settlement can be excruciating. It is not always patient; it is not always kind. It can be rude. Self-seeking. Easily angered. And if you've developed a comfortable nest of 401k funds, you may find these benefits at the center of your divorce settlement maelstrom.
"I've seen 401k participants who've been abandoned by their spouses. Participants who've been left with kids to support and a household to run," says Ted Benna. "I've also seen participants with huge account balances doing irrational things - like forbidding plan administrators to work with their spouse's divorce lawyers - all in an attempt to keep their spouses from getting any of the retirement benefits."
Your desire to protect your funds may be self-seeking. Or it may be a matter of survival. But either way, your spouse has the legal grounds to claim all or part of your 401k benefits in a divorce settlement. And in most cases, you'll have to find a way to make a fair and equitable split of the funds. By being organized, prepared and knowledgeable about your legal options and rights, you can split your 401k reasonably.
Know Your Plan, Know Your Options
When deciding how to divvy up your 401k account with your soon-to-be ex, start by discussing options with your plan administrator. "A lot of what you can do with your 401k is directed by the plan," says Laura Johnson, a family law paralegal and author of Divorce Strategy: Tactics for a Civil Financial Divorce.
Each plan has its own set of benefit provisions and administrative rules. While some plans divide earnings by percentage, others divide by shares. And while some permit a distribution of the ex-spouse's portion at the time of the divorce, others require recipients to wait until retirement. "Before you talk to your lawyers and financial planners and accountants - and well before your divorce decree is drafted - you need to do your own research into your plan's guidelines," says Johnson. "And don't expect anyone else to do it for you," she warns. "Because in many cases, they won't."
The Equitable Split: Four Common Options
Once you've researched your plan administrator's rules and stipulations, you'll likely have one or more of the following options for dealing with your 401k in the divorce decree.
Option 1: You keep all of your 401k, and your spouse takes other marital assets of comparable value.
This option is sometimes cited as the least complicated from the attorney's point of view, but it requires careful research and financial calculations. If you choose this route, you'll need to consider at least two economic factors to ensure that you and your spouse remain on equal financial footing: 1) your long-term tax consequences and 2) the current and long-term values of the assets being divided.
You'll need to subtract the imputed tax - the tax you'll eventually have to pay on the amount in your account - from the value your 401k will hold at the time of your retirement.
On the other side, your soon-to-be ex will want to weigh the long-term value of the 401k against the long-term value of the assets he or she is receiving. For instance, if your 401k is worth $100,000 at the time of the divorce, and you have a fairly long time horizon until retirement [during which your account will earn compound (tax-deferred) interest], your 401k may be worth much more than $100,000 at the time of your retirement. Your ex will want to ensure that his or her share of the marital assets will be equally valuable over the long haul.
Option 2: You and your ex-spouse split the 401k assets.
If you want to split your 401k account with your ex rather than hashing out a division of marital assets equal in value to the 401k, then you will need a Qualified Domestic Relations Order. A QDRO (pronounced "quadro") is a court order that creates the right for an alternate payee (in this case, your ex-spouse) to receive all or part of your plan account. The QDRO must be a judgment, decree or order that is made pursuant to a state domestic relations law and relates to the provision of child support, alimony payments or marital property rights.
According to Benna, the least complicated procedure is often for the QDRO to stipulate that your 401k plan will be split into two accounts. This would enable you to continue to manage and contribute to your account as before, while your ex-spouse could make investment choices for his or her account, but not contribute to it. When you retire and become eligible to receive distribution of your funds, most 401k plans are set up so that your ex-spouse will also be eligible for distributions.
If you choose to divide your 401k, you may have to iron out issues such as repaying an outstanding loan, and how to allocate any earnings or losses that occur between the date of the divorce and the date the QDRO is made effective by the plan administrator.
"The drafting of a QDRO is a sensitive spot," says Johnson. "Because many divorce lawyers don't investigate a particular pension plan's guidelines before giving advice to clients on separation agreements, they often submit inadequate QDROs to plan administrators." And if the QDRO contains vague language or doesn't conform to plan guidelines, your plan administrators will reject it. It will then have to be re-drafted by your lawyer or your ex-spouse's lawyer. This, of course, results in additional fees. And more emotional hardship.
"Because of problems with QDROs, I've seen lag times of several months - or even years - before QDROs were accepted by plan administrators and the 401k plans were actually divided," says Johnson. "It takes an emotional toll. People feel like their divorce will never go away."
The moral? Understand your plan administrator's guidelines for splitting the 401k before your attorneys begin drafting the QDRO. Share this information with your attorneys. And begin the drafting process early in your discussions, so you'll have time to get it accepted by the plan administrator as part of the divorce settlement.
Option 3: You liquidate the portion of your account that is needed to satisfy the QDRO, and you give your spouse a lump sum.
This option is generally available only if you meet the rather complex legal requirement to permit such a distribution. Because of the tax consequences, this will probably be the least desirable option for both you and your spouse. "Except in a few extreme situations, liquidating is not a good idea," says Johnson. But if you are the one trying to get part of your spouse's 401k, and you need the cash to pay off credit card debt or to maintain a separate household while your divorce is pending, this may be the least ugly of an unattractive array of options.
If it is your account, and part of it is liquidated for your spouse, you might want to make certain that your spouse is liable for the tax consequences. "Your agreement needs to be clearly drawn," says Benna, "so that the liability is borne by the spouse receiving the benefits."
Option 4: Roll the portion of the 401k awarded to the ex-spouse into an IRA.
This option is only available if you've left your company or you're over the age of 59 ½. The benefit here is that a rollover permits you to remove your ex's share from your 401k plan without any penalty or tax liability. It also gives your former spouse an opportunity to choose from a wider array of investment choices, and to exercise more self-direction in account management.
If Both Spouses Have 401k Accounts
If you each have your own 401k, the division will depend on the dynamics between the two of you, says Johnson, as well as your account balances. Some couples can't agree on anything but a 50/50 split of all assets, including both 401ks. Other couples are happy to avoid the QDRO paperwork and simply each keep their own 401ks. In cases where one spouse's 401k balance is much larger than the other's, a solution may be for the person with the smaller balance to receive part of the other person's account.
A Kinder, Gentler Divorce
The financial storms that swirl around a divorce settlement can wreak havoc on your pocketbook, your emotions and your dignity. "I've seen some difficult stuff," says Benna, a benefits consultant for nearly 40 years and the architect of the first 401k program. "I've seen participants who haven't acted with the necessary respect and knowledge, and I've watched them lose everything."
It doesn't have to be this way. By making it your goal to be knowledgeable and fair-minded when negotiating the split of your 401k, you can protect an equitable share of your financial assets. And you can keep an even larger share of your emotional well-being.
Avoid the Trauma: Seven Tips From the Trenches
"You must enter into the process of splitting marital assets with your eyes open," says Johnson. Benna agrees. "You need to be fully informed. If you're not careful, you can end up losing your whole benefit."
The following tips can arm you with the knowledge you need to avoid both headache and heartache when splitting your 401k.
1. Ask your CPA and your financial planner for advice. Because tax consequences and liability will be different for each participant depending on age, income bracket and other factors, it's essential that you discuss the specifics of your situation with a finance and accounting professional.
2. Ask your plan administrator for model copies of QDROs.
3. Ask your plan administrator for guidelines and a checklist for preparing the QDRO. Some large employers will provide QDRO kits to help you. When researching your plan's guidelines, amass all the literature you can, and read it carefully.
4. Give both sets of lawyers copies of all guidelines and documents you receive from the plan administrator. Make it your job to ensure that both sets of attorneys are familiar with your plan's guidelines. "It's essential that the claim submitted complies with the plan," says Benna. And it's all too common for claims to be filed erroneously.
5. Make sure that QDRO is prepared at the time of the divorce.
6. Sign the QDRO when you sign the separation agreement. Your divorce decree will be one crucial step closer to finalization once you sign the QDRO. And if you don't sign it with your separation agreement, you'll be one step further from bringing your divorce to closure.
7. Factor your spouse's benefits into your negotiations. The options and provisions for splitting a 401k apply to all retirement benefits. By factoring your spouse's retirement benefits into the negotiations, you may be able to hold on to a larger portion of your 401k.
The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.