When you are in the midst of a divorce, the emotional toll itself is hard enough to manage. However, there are also many thorny financial issues that will need to be addressed. A legal separation will most likely involve the division of your retirement plan assets which, if not done properly, can create big tax headaches and other issues down the road. The type of retirement plan, whether it be an IRA or qualified plan determines the rules that will apply to you.
Retirement accounts are frequently the largest liquid assets in a divorce proceeding. The number one issue relating to the distribution of retirement assets during a divorce is taxation. Transfers from one spouse’s IRA to another spouse’s IRA must be done correctly to avoid an unintentional distribution and the related penalties. Likewise, dividing qualified plans such as 401(k)s, Defined Benefit plans, or pension plans requires a qualified domestic relations order (QDRO). Both spouses should know and clearly state which category each of their retirement assets fall under in order to avoid any unnecessary problems later on.
An IRA division needs to be treated as a transfer "incident to divorce" and should be completed within one year of the divorce settlement. Any transfers after the one-year mark are subject to review by the IRS. After the transfer, the recipient will assume the responsibility for investing those assets and make any future decisions on distributions. Be sure to label your transfer appropriately, for if you fail to classify your transfer as "incident to divorce," both of you will be subject to the early withdrawal penalty. The instructions you provide need to be approved by both the sending and receiving IRA custodians as well as the judge and state courts. If not properly approved, then the amount will be sent to your ex as ordinary income and will be subject to taxes.
When qualified plans are divided between two parties, a QDRO is required. The person whose interest is being transferred is called the "participant", and the person to whom the interest is transferred to is called the "alternate payee." This person is usually the divorcing spouse, but it could also be a child. Like transfers incident to divorce, QDROs are tax-free transactions as long as they are reported correctly to the courts and IRA custodians. The receiving spouse has the option of adding these assets to an IRA or his or her own qualified plan. Make sure you clearly define your transfer from your qualified plan as a QDRO because if you fail to do so, the transfer is subject to taxes or penalties.
One last caveat after transferring any assets is to add or change your beneficiaries. In qualified plans, there is less flexibility in terms of options for designated beneficiaries. In a 401(k), if one spouse does not change his or her beneficiary designation, the assets will go to the ex no matter what the will states. On the other hand, IRAs are not governed by state laws and do not automatically grant beneficiary rights to the spouse. Therefore, if your ex-spouse gave up any claim to retirement assets in a divorce, make sure your IRA beneficiary designation form is updated to reflect that change.
Knowing how to divide your retirement assets and also avoid any unnecessary tax consequences will prevent any unnecessary tax problems. While the rules for both an IRA and a qualified plan division are similar, it is essential to know what rules apply to you. Divorce is never easy but educating yourself on the proper way to handle your finances will make it easier for you to move on with your life.