Dividing Retirement Accounts Without Creating Avoidable Tax Problems
Retirement accounts can represent a substantial part of a couple’s wealth after years of marriage. A 401(k), pension, IRA, or other retirement benefit may have grown through decades of contributions and investment gains, and part of the account may have been accumulated before the marriage. During divorce, the spouses may need to determine how much of the benefit is marital property, how each spouse will receive an agreed or court-ordered share, and what tax consequences can follow from the method used to divide it.
Moving retirement assets requires particular care because different accounts follow different transfer and distribution rules. A method that works for an employer-sponsored retirement plan may not work for an IRA, and taking money out can have different consequences from transferring it between retirement accounts. When retirement savings are part of a Virginia divorce, working with an experienced Leesburg property division attorney can help identify the marital share and address the different rules that can affect how those assets are divided.
Retirement Benefits Can Be Marital Property in Virginia
Retirement savings accumulated during a marriage can be part of the property divided in a Virginia divorce. Under Virginia Code § 20-107.3, pensions, profit-sharing plans, deferred compensation plans, and retirement benefits can fall within marital property to the extent they were earned during the marriage and before the parties’ last separation, when at least one spouse intends the separation to be permanent. An account can contain both marital and separate interests when a spouse had retirement savings before the marriage and continued contributing afterward.
Separating those interests can require looking beyond the account’s current balance. Contributions made during the marriage, investment changes, and the history of the account can affect how much of the retirement benefit is subject to division. When older statements are missing or funds have been moved between accounts, records showing earlier balances, later contributions, rollovers, and other account activity can help establish what was accumulated before and during the marriage.
Tax treatment is also part of the financial picture when spouses divide their property. Virginia Code § 20-107.3 includes the tax consequences to each party among the factors a court considers in dividing marital property or determining a monetary award. A retirement account carrying future tax obligations may have the same stated balance as another asset without giving the recipient the same amount of spendable money.
A Retirement Account Is Different From Cash in the Bank
A retirement account balance can create a misleading impression during settlement discussions. A spouse who receives $200,000 in retirement assets is not necessarily receiving the economic equivalent of $200,000 in an ordinary bank account. The retirement funds may remain invested for years, while money in a savings account is generally available for immediate use.
Receiving an interest in a retirement account also does not mean the recipient must immediately withdraw the money. Depending on the account and the method used to divide it, the funds may remain invested or move into another eligible retirement account. Taking a distribution in cash is a separate decision that can trigger tax consequences that would not arise from an eligible rollover.
Access to the money can influence negotiations as well. A spouse who expects to leave retirement savings invested may have different priorities from someone who needs funds for housing or other expenses after the divorce. Looking beyond the balances can help the parties compare assets according to both their value and how they can actually be used.
Employer Retirement Plans Often Require a QDRO
Many employer-sponsored retirement plans require a Qualified Domestic Relations Order, commonly called a QDRO, before the plan can pay part of a participant’s benefits to a former spouse. A QDRO creates or recognizes an alternate payee’s right to receive all or part of the benefits payable under a covered retirement plan. The U.S. Department of Labor provides guidance on the requirements these orders must satisfy.
The terms used in the divorce agreement also need to match what the plan can provide. A settlement may award a percentage of a 401(k) or pension, but the valuation date, treatment of gains and losses, payment timing, and survivor benefits can affect what the former spouse ultimately receives. A QDRO cannot require a plan to provide a type or form of benefit that the plan does not otherwise offer.
Virginia Code § 20-107.3(G) authorizes a court to direct payment of a percentage of the marital share of pension, profit-sharing, deferred compensation, and retirement benefits. Virginia law defines the marital share for this purpose as the portion of the total interest earned during the marriage and before the parties’ qualifying last separation.
A QDRO Does Not Make a Retirement Distribution Tax-Free
A QDRO determines the former spouse’s right to receive benefits from a covered retirement plan. Federal tax law separately determines how a distribution is taxed. A spouse or former spouse receiving benefits under a QDRO generally reports the payments as a plan participant would, while an eligible distribution that is rolled into an IRA or another eligible retirement plan can generally continue to receive tax-deferred treatment.
Keeping the distribution in cash produces a different result. The taxable portion generally becomes current income to the spouse or former spouse who receives it. A direct rollover, by contrast, moves eligible funds into another retirement account without treating the rolled-over amount as current taxable income.
The 10% additional tax on certain early retirement distributions is a separate issue from ordinary income tax. Internal Revenue Code § 72(t)(2)(C) provides an exception from that additional tax for a distribution to an alternate payee pursuant to a QDRO. The exception does not turn a cash distribution into tax-free income; it removes the additional 10% tax when the statutory requirements are met.
IRAs Follow Different Transfer Rules
IRAs do not use a QDRO simply to divide an account between divorcing spouses. Internal Revenue Code § 408(d)(6) provides that an IRA interest transferred to a spouse or former spouse under a qualifying divorce or separation instrument is not treated as a taxable transfer. After the transfer, the interest is treated as the recipient spouse’s IRA.
A direct trustee-to-trustee transfer can move the appropriate IRA assets into an IRA for the other spouse without first paying the funds to the account owner. The money retains its retirement-account status, and the recipient generally becomes responsible for the tax consequences when taxable distributions are later taken.
Withdrawing money from the IRA and then using the cash to satisfy the divorce agreement is different from transferring the IRA interest under § 408(d)(6). The withdrawal can be taxable to the account owner and may also be subject to the 10% additional tax when the owner is under age 59½ unless another exception applies. Unlike the rule for distributions to an alternate payee under a QDRO, the domestic-relations exception in § 72(t)(2)(C) does not apply to IRA distributions.
Retirement Terms Need to Be Addressed Before the Divorce Is Final
A property settlement involving retirement benefits should accurately identify the account or plan and define the portion being divided. The agreement may also need to address the valuation date and treatment of investment gains or losses between the relevant dates. An outstanding loan against a workplace retirement account can affect the balance available for division and may need to be accounted for when the spouses negotiate their shares.
Defined-benefit pensions present different concerns because there may be no individual investment balance to divide immediately. The parties may instead be allocating rights to a future stream of payments, and survivor benefits can affect what happens after the participant dies. A 401(k), pension, traditional IRA, and Roth IRA can require different treatment even when they appear together on the same marital asset schedule.
Problems with retirement terms can be harder to resolve after benefits have been distributed or the divorce is final. Before the agreement fixes each spouse’s share, working with a knowledgeable Leesburg Property Division Attorney can help identify how the proposed terms will work with the accounts and retirement plans being divided.
Speak With Our Leesburg Property Division Attorneys
If retirement savings make up a significant part of your marital property, decisions about classification, valuation, and the method of transfer can affect what each spouse ultimately receives. Addressing those issues before the divorce is final can also help avoid problems when the retirement plan or financial institution implements the agreement.
Simms Showers LLP represents individuals and families in Leesburg and throughout Northern Virginia in divorce and property division matters. Contact us to speak with an experienced Leesburg property division attorney and learn how we can help you address the division of retirement assets during your divorce.
This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers Law expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum.
Sources:
- Virginia General Assembly — Code of Virginia § 20-107.3, Court May Decree as to Property and Debts of the Parties
https://law.lis.virginia.gov/vacode/title20/chapter6/section20-107.3/ - S. House of Representatives, Office of the Law Revision Counsel — 26 U.S.C. § 72, Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section72 - S. House of Representatives, Office of the Law Revision Counsel — 26 U.S.C. § 408, Individual Retirement Accounts
https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section408 - S. Department of Labor — QDROs: The Division of Retirement Benefits Through Qualified Domestic Relations Orders
https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/publications/qdros - Internal Revenue Service — Retirement Topics: QDRO, Qualified Domestic Relations Order
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-qdro-qualified-domestic-relations-order - Internal Revenue Service — Retirement Plans FAQs Regarding IRAs
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras - Internal Revenue Service — Publication 504, Divorced or Separated Individuals
https://www.irs.gov/publications/p504
