Avoid Five Costly Mistakes in Dividing Retirement Assets During Divorce

Avoid Five Costly Mistakes in Dividing Retirement Assets During Divorce

Addressing these issues at the outset can prevent future litigation 

From a wealth management standpoint, the most critical component of property division in divorce is the careful handling of qualified and non-qualified retirement assets. Too often, couples simply slice traditional retirement assets down the middle, but a more thoughtful approach proactively considers the realities of post-divorce needs and analyzes the long-term benefits imbedded in the assets subject to division (especially in the context of high-net-worth (HNW) estates. Marshalling these improved outcomes requires a working knowledge of the legal parameters for dividing Employee Retirement Income Security Act (ERISA)-qualified retirement assets and other non-qualified assets.

The vast majority of all private-sector retirement plans in the United States are designed and maintained to qualify for favorable tax treatment through compliance with ERISA by which: 1) employers may deduct contributions made to the plan; 2) employees may defer tax liability for contributions to the plan; and 3) the funds held in the plan grow tax-free until withdrawn by the plan participant.

To maintain the integrity of these federally regulated and tremendously valuable tax benefits, federal law doesn’t permit a plan participant in an ERISA-qualified plan to make early withdrawals of plan assets without penalty.

Exception: Assets held in qualified retirement plans may be divided without penalty for purposes of child support, alimony and equitable division of marital property through the use of a domestic relations order which, once accepted—or “qualified”—by the qualified plan’s administrator, is known as a qualified domestic relations order (QDRO).                

QDROs are required to divide assets held in ERISA-qualified plans in connection with divorce, but aren’t required to divide individual retirement accounts or other non-qualified plans, such as deferred compensation plans, supplemental pension plans, long-term incentive plans or stock ownership plans.

Five Issues

To avoid costly mistakes in the division of these assets, give special care to these five issues:

1. Anticipate and minimize tax liability that may arise from cash distributions taken on QDRO transfers.

A straightforward rollover from a plan participant’s qualified defined contribution plan (for example, a 401(k) Plan) to the former spouse’s eligible retirement account is a non-taxable event. But any time the former spouse elects to take all or a portion of the benefit in cash, two taxation issues arise: 1) the potential assessment of an early distribution penalty; and 2) the income tax liability that will be triggered by the cash distribution. Although the income tax is unavoidable, the early distribution penalty can be avoided on transfers by QDRO so long as the alternate payee elects to receive the cash at the time he elects the form of distribution prior to the rollover of the benefit into another eligible plan.

2. Define how the pension plan will be divided.

Vastly different post-divorce outcomes are possible for the former spouse depending on the method that is used to divide the pension and the elections that are made at the time of division regarding the survivorship options. One method is inherently favorable to the plan participant (the shared interest approach); and the other is inherently favorable to the former spouse (the “separate interest approach”). Advisors should consider: 1) which approach is most beneficial; and 2) the appropriate elections that should be made to ensure maximum survivorship options for both parties.

3. Divide the tax basis for after-tax contributions to defined contribution plans.

Not all 401(k) plans permit the plan participant to make after tax contributions to the plan in addition to pre-tax contributions; but when the plan participant has been permitted to do so, and especially in HNW cases, this issue should be addressed during the division.

To capture the total value of the assets in the plan, broadly define the former spouse’s benefit to include a pro rata share of the tax basis for after-tax contributions. A recent Internal Revenue Service ruling makes it easier to convert after-tax contributions from a 401(k) to a Roth IRA.1

As a result, it’s important to explore whether the former spouse might be eligible to benefit from this ruling in handling the investment of the rollover assets.

4. Pro-rate contributions to defined contribution plans through the divorce date, regardless of the timing of the contribution.

When the employer makes an annual contribution to the plan at the conclusion of the plan year, instead of monthly contributions to the plan, the former spouse’s interest in the plan should be broadly defined to include a pro rata share of all contributions to the plan accrued through the date of divorce regardless of the time the contribution is made to the plan.

5. For non-divisible, non-qualified retirement plans, include a formula to allocate the tax consequences of future payments.

Distributions from non-qualified plans, such as deferred compensation plans, always have tax consequences to the recipient. Because the majority of non-qualified retirement plans aren’t immediately divisible in connection with divorce, the plan participant must be required to hold the former spouse’s divided interest in constructive trust for the benefit of the former spouse and to then pay the former spouse his share of the net income received.

Thus, it’s critical to address the requirement that the divided assets shall be held in constructive trust for the benefit of the former spouse; the terms for the plan participant’s obligation to pay the former spouse his share of net distributions as they’re received; and the formula for the reconciliation of each party’s respective tax liability on future distributions.

Addressing these issues at the time the assets are divided will avoid inequitable and unintended results and will hopefully insulate the parties from post-divorce litigation.

Endnote

1. Internal Revenue Service Ruling 2014-54.

 

 

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