Retirement accounts are often among the largest marital assets that must be divided in divorce. Whether you are splitting a 401(k), IRA, pension, or defined benefit plan, it’s crucial to be aware of the potential tax consequences before any transfer occurs. A misstep can trigger an income tax, result in early-withdrawal penalties, and lead to long-term financial consequences. Knowing how these accounts are taxed, both at the time of transfer and upon future distribution, can help avoid costly mistakes and preserve the value of the retirement savings.
The following are some key considerations when it comes to handling taxes on retirement accounts during and after divorce:
Identify the Type of Retirement Account
The tax rules can vary significantly based on the type of retirement account. While different plans are governed by different rules, it’s critical to understand the distinctions before any funds are transferred or distributed. Common types of retirement accounts divided in a divorce can include the following:
- Employer-sponsored defined contribution plans: Plans such as 401(k)s and 403(b)s are typically funded with pre-tax dollars and subject to specific federal rules regarding division in divorce, including the requirement of a Qualified Domestic Relations Order (QDRO), compliance with the federal Employee Retirement Income Security Act (ERISA), and plan-specific administrative procedures.
- Traditional IRAs: Traditional IRAs are funded with pre-tax dollars, meaning the contributions made were tax-deductible. Distributions are generally taxed as ordinary income when withdrawn. As with other plans, they get split pursuant to a separation agreement or divorce decree and not taxable to the recipient until the funds are withdrawn.
- Roth IRAs: Roth IRAs are funded with after-tax dollars, so qualified distributions may be withdrawn tax-free. The transfer must be made pursuant to a divorce decree and structured properly to avoid taxes and penalties.
- Defined benefit plans (pensions): Defined benefit plans provide a future stream of income in the form of monthly payments at retirement, rather than maintaining an individual account balance. Division typically requires a QDRO that specifies how the benefits will be allocated. Taxes are generally paid when the benefit is distributed.
Because each type of account has unique distribution requirements, rollover procedures, and tax implications, accurately identifying the plan at issue is the first step in avoiding unintended tax consequences and penalties.
Understand the Early Withdrawal Rules
Early withdrawal penalties typically apply to retirement accounts such as 401(k)s, 403(b)s, and IRAs if funds are taken out before age 59½. In most cases, early distributions also trigger a 10% federal penalty in addition to ordinary income tax on the amount withdrawn. However, there are certain exceptions to the early withdrawal penalty in the context of divorce, such as when distributions are made pursuant to a QDRO. A tax professional can best advise on the early withdrawal rules and tax consequences for a specific type of account.
Know When a QDRO is Necessary
Certain employer-sponsored plans, such as 401(k)s and 403(b)s, require a QDRO to divide a retirement account pursuant to divorce. A properly executed QDRO allows funds to be transferred to an ex-spouse without triggering immediate income tax or the early 10% tax penalty. However, the recipient spouse will later owe income tax when they withdraw funds.
Although Traditional and Roth IRAs do not require a QDRO, they must be divided pursuant to a divorce decree and structured as a trustee-to-trustee transfer. When done correctly, the transfer is treated as a tax-free transfer incident to divorce and is not taxable to the original account holder.
Use Rollovers Whenever Possible
A rollover directly moves retirement funds to another tax-advantaged account without triggering immediate income taxes or early withdrawal penalties. It also avoids “cashing out,” which occurs when funds are paid directly to the spouse and can result in a mandatory tax withholding and potential penalties. Importantly, a rollover ensures the savings continue to grow tax-deferred (or tax-free, depending on the type of account), keeping the funds invested for the future.
Consider Future Taxes
Even when a transfer doesn’t have immediate tax consequences, it’s vital to plan for the future. Most retirement account distributions will be taxed as ordinary income when they are eventually made. This means that if one spouse receives a larger share of pre-retirement assets, that spouse may ultimately bear a greater tax burden. In addition, required minimum distributions, the timing of withdrawals, and each party’s anticipated tax bracket at the time of retirement should be taken into consideration when negotiating a settlement. Evaluating the after-tax value of retirement assets, rather than focusing solely on the account balance, can allow spouses to negotiate from a more accurate financial perspective — and lead to a more balanced outcome. The after tax value is a critical analysis that should be done in every divorce.
Contact an Experienced Tax Professional
If you are facing divorce, it’s essential to have a tax professional who can advise you regarding the tax consequences of dividing retirement accounts. At Rolleri & Sheppard, CPAs, LLP, we offer a wide range of tax and accounting services to clients throughout the divorce process to help ensure they make informed financial decisions. Contact us online or call (203) 259-CPAS to schedule a consultation to learn how we can assist you.
