What Happens to Retirement Funds and 401(k) Plans in a Divorce?

While dividing assets like the house and car and settling issues related to child custody, support, and alimony often take center stage in divorce, how retirement assets should be divided deserves a great deal of attention. Retirement funds must be divided carefully to avoid significant tax consequences and the assets should be divided fairly. Special rules also apply to the division of any retirement accounts during a divorce.

Is a Spouse Entitled to the Other's Retirement Account?
In a divorce, assets are considered either separate property or marital property. Separate property is typically very limited and includes:

• Property owned by either spouse before the marriage
• Money received through a personal injury attorney, if not mingled with marital assets in a joint account
• Property that has been designated as separate with a prenuptial or postnuptial agreement
• A gift received by one spouse from a third party
• An inheritance received by one spouse (before or after marriage) if not mingled with marital assets

In most cases, any assets earned or acquired during the marriage are considered marital property. This means one spouse is probably entitled to a share of the other spouse's 401(k) or retirement account.

How Are Retirement Funds Distributed?
Every state has rules on how assets and debts are divided in a divorce. In community property states, all assets and debts acquired during the marriage are community property. This means both spouses own the property 50-50 and the assets must be divided equally between the spouses at divorce. This includes retirement accounts. In states using the equitable distribution method, a judge will divide assets as he or she believes is equitable, but this may not be equally.

It's important to understand that spouses can also make agreements about debts and assets during the divorce. This is crucial when it comes to retirement accounts. Spouses can make an agreement on how retirement accounts will be divided, if at all. For example, one spouse may keep their retirement funds or 401(k) in exchange for the family home.

A Court Order is Necessary to Divide a 401(k) or Pension
If either spouse has a 401(k) that will be divided in the divorce, doing so is not as straightforward as splitting money in a checking account. A judge must first sign a Qualified Domestic Relations Order that confirms each spouse's right to a share of the money in the account. This order also allows the spouse who owns the account to avoid paying an early withdrawal penalty and taxes on the distribution.

If other employer-sponsored plans like a pension will be divided, a special court order must be obtained for each account. These court orders detail the exact dollar amount or percentage te other spouse will receive.

An IRA does not require a court order to divide, but a process known as transfer incident to divorce must be used to split the assets to avoid tax consequences.

Distribution Options for a 401(k) After Divorce
The spouse who receives a 401(k) distribution after a divorce has options for receiving the funds:

• Roll the assets into their own qualified retirement plan through a direct transfer. This option avoids paying a penalty.
• Defer the distribution until the other spouse retires. Using this option, the receiving spouse can receive regular payments or a lump sum. If the money is left in the 401(k), the receiving spouse can begin taking minimum distributions at the age of 70-1/2 without paying a penalty.
• Cash out the money. This can be expensive as the receiving spouse will pay income taxes on the money and a 10% early withdrawal penalty if the money is withdrawn before the age of 59-1/2.

Dividing retirement funds in a divorce can be very complicated. It's important to discuss the consequences and the best way to divide assets with a tax adviser and a divorce attorney.