IRAs, 401(k)s, and Divorce: Is There a Difference?

Most people have some form of retirement savings, either individually, through work, or both.  If individual, it falls under the Individual Retirement Account (IRA), which has several forms with different tax consequences (whether taxable at the time of deposit or time of withdrawal).  If work, it falls under an ERISA program known as a 401(k).  Generally, in a 401(k), an employee makes monthly contributions and the employer makes matching contributions.

Retirement savings accumulated during the marriage are considered marital property.  Consequently, in the event of divorce, each spouse has a claim to half the marital portion of the other spouse’s retirement savings.

Whether the parties by a separation agreement or the court award a spouse a share of an IRA or a 401(k), the method of transfer of that asset will differ based on the type of retirement account.  An IRA is held individually, and under the Internal Revenue Code, a spouse may “rollover” funds into another IRA tax free, i.e. no tax due on the capital gain.  The “rollover” includes putting the funds into an IRA for the former spouse.  So, the transfer of a set portion or sum of an IRA to a former spouse involves little more than signing a form.  But if the rollover does not occur within a short time window, the recipient will face a tax penalty.

The 401(k) involves much more.  Under ERISA, a former spouse can claim the marital portion without tax consequences only if executed through a Qualified Domestic Relations Order (QDRO).  Each plan has different requirements for a QDRO, and the attorney preparing it must take care to comply with all of the terms.  Once the plan administrator approves the QDRO, the attorney will have the court sign off on the QDRO and after submitting it to the plan administrator the former spouse will have a separate 401(k) that will pay benefits according to the terms of the plan.

Both retirement plans become a form of taxable income after retirement.  For example, a 401(k) often pays a monthly benefit, and that monthly benefit will be considered taxable income.  An IRA, by contrast, has different forms of payment and works like an actual savings account where you make withdrawals – except every withdrawal becomes taxable income.  So, in terms of planning for retirement, a spouse should consider his or her anticipated use of the retirement benefit and consult with a financial planner as to the preferred tax structure, particularly if the spouse has a choice between an IRA and a 401(k).

Both types of retirement accounts allow for borrowing against the principal, but will have different payment systems and time limits.  An IRA allows the spouse to “cash in” at any time; however, any early withdrawal comes with a severe tax penalty.  On the other hand, some 401(k)’s will not allow for early withdrawal.

Given these differences, a spouse contemplating divorce should consult both an attorney and a financial advisor before deciding upon a particular division of retirement accounts.

If you have questions about a 401(k) or IRA and divorce, contact us – we can help.