Retirement plans in divorce

August 3, 2022

By Terry Donahe, CFP®, CDFA®, Springwater Wealth Management

Saving for retirement is one of the greatest challenges facing Americans. While government pension plans still exist, few corporations provide them. Saving in employer-sponsored retirement accounts is limited. Saving outside of work is a struggle for many people. Social Security is underfunded and, consequently, its benefits will eventually be scaled back.

So when a divorce occurs, the division of retirement accounts is among the most important components of the settlement. It is also among the most complex. As a result, mistakes are made. Let’s review retirement plans.

Categories of Retirement Plans
There are three categories of retirement plans:

- Plans that are provided by companies for their employees which are governed by ERISA (the Employee Retirement Income Security Act) law.
- Plans that fall under federal and state law, but which do not fall under ERISA.
- Plans that receive certain tax advantages under the Internal Revenue Code.

ERISA Retirement Plans — Defined Benefit and Defined Contribution
Under ERISA, there are two broad types of retirement plans.

In a defined benefit plan, the employer provides participants a specific monthly benefit (often described as an annuity) at retirement. The benefit may be stated as a specific dollar amount. More commonly the benefit will be calculated based on a formula that includes factors such as salary, age, and number of years worked for the employer. The benefit may be indexed for inflation. It is noteworthy, that employees do not have a separate account in these plans. Defined benefit plans are pooled. There is no cash value.

In a defined contribution plan, the employer and employee contribute to an account in the employee’s name. Employees decide how much of their pay to contribute, subject to limits. They also decide how the account balances are invested. The employer may contribute to the employee’s account, often through matching a percentage of the employee’s contributions. The value of the employee’s account is a function of employee contributions, employer contributions, investment performance, and plan expenses. Defined contribution plans include: 401(k), Roth 401(k), SIMPLE IRA, Simplified Employee Pension (SEP), Employee Stock Ownership Plan (ESOP) and profit sharing.

Non-ERISA Retirement Plans
There are retirement plans to which ERISA does not apply. An employer providing a non-ERISA plan does not contribute to the plan. In addition, there are limits on the administrator for a such a plan.

There are two categories of non-ERISA plans. Plans can qualify under the Department of Labor’s safe harbor provision which includes several requirements. Plans can also qualify, if they fall into one of the special exemptions for governmental plans for federal, state and local governments, “church plans” for religious organizations and private sector 403(b) plans established by 501(C)(3) tax-exempt organizations that meet certain requirements.

The military’s retirement plan is also not subject to ERISA.

Non-Qualified Employer Retirement Plans
There are still other retirement plans that are not covered by ERISA rules. These non-qualified retirement plans are used by employers to provide highly-compensated executives with supplemental retirement savings. Non-qualified plans include deferred compensation, executive bonus, split-dollar life insurance, and group carve-out.

Contributions to these plans are not deductible to the employer. The contributions become taxable to the executive when they are received, typically in retirement.

Other Personal Tax-Advantaged Retirement Plans
There are two other personal retirement savings accounts which are widely held. Very briefly, they are:

The traditional Individual Retirement Account (IRA). Contributions to a traditional IRA may be fully or partially deductible depending on the taxpayer’s filing status and income. Amounts in a traditional IRA (contributions and earnings) are generally not taxed until they are distributed. In general, withdrawals cannot be taken from a traditional IRA before age 59 ½ and they must begin by age 72.

The Roth Individual Retirement Account (IRA). There is no deduction for contributions to a Roth IRA (i.e., they are made after-tax). If certain requirements are met, qualified distributions are received tax-free. Withdrawals can be taken from a Roth IRA after a five-year holding period. However, there are no minimum distribution requirements.

There are combined contribution limits that apply to an individual’s combined traditional and Roth IRAs.

Valuing Retirement Plans
The valuation of retirement plans depends on the type of plan.

Defined benefit plans represent a promise by an employer to pay a participant income in the future. There is no separate employee account with a current value. Instead, the present value of the employee’s future benefit must be calculated. The factors involved in the calculation include the participant’s age, life expectancy, and retirement age and a discount rate. Note: The pension statement is not a reliable indication of the actual value of a participant’s pension.

The coverture faction is used to calculate the marital and non-marital portion of a defined benefit pension plan. The numerator of the fraction is the number of years of participation in the employer’s plan during the marriage. It usually starts with the date of marriage and ends with the date of divorce. The denominator is the total number of years of employment with the employer. It usually starts with the date of entry into the plan and ends with the date of divorce. The resulting fraction provides the portion of the benefit that is considered marital. The non-marital portion is simply the remaining amount of the benefit.

Defined contribution plans provide employees with an individual account. That account will usually hold securities (e.g., mutual funds, exchange-traded funds, and annuities) which can be readily valued.

Non-ERISA retirement plans and non-qualified retirement plans can be valued based on the nature of their benefits. Plans providing future benefits can be valued using a present value calculation. Plans with accounts which hold marketable securities are easily valued.

Dividing Retirement Benefits
The process of dividing a retirement benefit depends on the nature of the plan. Benefits from qualified plans that fall under ERISA are divided by a Qualified Domestic Relations Order (QDRO).

ERISA retirement plans can be divided in two ways. Under the shared payment method, the QDRO establishes the amount or percentage of the participant’s payments that will be allocated to the alternate payee and the number of payments or period during which the allocation to the alternate payee is to be made. Under this approach, the alternate payee will not receive payments unless the participant receives payments. Under the separate interest approach, the QDRO assigns to the alternate payee a percentage or dollar amount of the participant’s account balance as of a specific date.

Benefits from non-ERISA retirement plans, non-qualified employer retirement plans, and personal tax-advantaged plans are divided by the divorce decree or via a Domestic Relations Order (DRO).

Transferring Retirement Benefits
The transfer of ERISA retirement benefits is addressed in the QDRO. Typically, but not always, the alternate payee’s interest in a participant’s defined benefit pension plan will remain with the plan. An alternate payee’s interest in a defined contribution benefit plan will either remain with the plan or will be transferred to an alternate custodian.

The conveyance of non-ERISA retirement benefits, non-qualified employer retirement plans, and other personal tax-advantage retirement accounts is done through a “transfer incident to divorce” as specified in the divorce decree. If the transfer of funds in such plans is done directly from custodian to custodian, there is no withholding for taxes. If, instead, funds are transferred to the recipient spouse, they must be “rolled” into a suitable account (e.g., IRA) within 60 days to avoid taxation on the entire amount. In addition, if the recipient spouse is younger than 59 ½, a 10% early withdrawal penalty will apply.

Distributions from a Retirement Plan
In general, distributions from retirement plans are subject to ordinary income taxes. Withdrawals taken before age 59 ½ are subject to a 10% early withdrawal penalty. There are several ways for an alternate payee to take a distribution from a retirement plan.

A one-time distribution from an ERISA retirement plan can be done through a QDRO. If the alternate payee is not yet 59 ½, under IRC §72(t)(2)(c) the distribution will not be subject to the 10% penalty. The distribution would occur before the retirement assets are transferred to a separate account. The distribution would be subject to ordinary income taxes. A distribution from an ERISA retirement plan will be subject to mandatory withholding of 20% for federal income taxes and possibly for state income taxes. This withholding may over- or understate the amount of taxes that are ultimately due on the distribution.

A distribution from a non-ERISA retirement plan, a non-qualified employer retirement plan, and an individual retirement account (IRA) will be subject to the premature 10% penalty (if the recipient is not yet 59 ½) and income taxes. There is no mandatory withholding for taxes for a distribution from these plans.

Under certain circumstances found within IRC §72(t), an individual may take distributions from an IRA before age 59 ½ and avoid the 10% penalty. Some of the exceptions are: to pay for qualified higher education, to pay for a house as a first-time homebuyer, to pay for unreimbursed medical expenses, and to pay health insurance premiums while unemployed. It is also possible to take substantially equal period payments which must generally continue for at least five full years, or if later, until age 59 ½.

Issues and Pitfalls in Dividing Retirement Plans
Retirement plans are complex and dividing them in divorce requires great care. There are many pitfalls that lurk for the unwary.

Loans
Loans within retirement plans can create challenges in the settlement. The plan administrator will consider a loan as an asset within the account. It should be added to the value of the account to determine the account’s proper value. The loan should be disclosed on the asset worksheet.

Loans are not permitted within Individual Retirement Accounts. So, a loan could not be transferred from a qualified plan with a loan to an IRA. The loan must remain in the qualified plan. Further, the maximum amount that may be borrowed from a qualified retirement plan is 50% of the vested account balance or $50,000, whichever is less. Imagine a 401(k) with a balance of $125,000 and a loan of $50,000 for a total account value of $175,000. It would not be possible to assign by QDRO half of the account ($87,500) to the non-participant spouse, because the remaining amount in the participant’s 401(k) account ($75,000 or $125,000 minus $50,000) would not satisfy the loan rule. The account would be deficient $6,250 and that amount would be immediately due and payable by the plan participant.

Distributions
If a non-participant spouse expects to need more than an initial distribution from an ERISA retirement plan, they should consider leaving the assigned interest within the plan. This would enable the non-participant spouse to take additional penalty-free withdrawals.

A non-participant spouse taking a distribution from an ERISA retirement plan should consider the 20% mandatory withholding. For example, if the need is for $100,000, then $125,000 should be requested in the QDRO.

Beneficiary Designation
The plan administrator will make payments based on the participant’s designated elections. There have been many cases in which a participant failed to name a beneficiary, named a beneficiary who is deceased, or named a beneficiary who is not the participant’s legal spouse/partner.

Advisors should review the participant’s elections in the context of reviewing.

The imperiled DB Plan
If the qualified retirement plan held by the participant spouse is underfunded or in jeopardy of becoming so, or is otherwise mismanaged, the non-participating spouse should carefully consider the risk of leaving an interest in the plan. While ERISA retirement plans are insured through the Pension Benefit Guarantee Corporation, the guarantee is limited and may not fully protect the participant’s original interest in the plan.

The Roth Account
Contributions to a Roth account (Roth IRA or Roth 401(k)) are made on an after-tax basis. These accounts grow tax-free.

In the process of arriving at a settlement, a Roth account must be valued correctly. Qualified distributions from a Roth account are tax-free. In contrast, distributions from a traditional IRA are subject to ordinary income tax. Therefore, the settlement calculations involving Roth accounts must be adjusted for taxes.

Government Defined Benefit Pensions
These plans generally provide limited benefits to the named survivor if the participant dies. For example, a participant in the Federal Employee’s Retirement System (FERS) receives a retirement annuity that is reduced 10% to give the participant’s surviving spouse an annuity of 50% of the participant’s unreduced benefit.

Read Qualified Plan Documents
It is imperative that those who are valuing retirement plans and crafting their division read the relevant plan document and IRS determination letter. While ERISA sets minimum standards for retirement plans in private industry, a sponsor’s plan will often contain unique provisions. For example, advisors should review the provisions for early and late retirement.

A QDRO must be written in a manner that is consistent with the plan. A QDRO cannot ask the plan to take an action (e.g., make payments) that the plan does not allow.

Points on the QDRO
The QDRO is not qualified until the plan administrator qualifies it. QDROs are routinely rejected for a variety of reasons.

The QDRO should be entered into court with the Judgement of Dissolution of Marriage. Too often the QDRO languishes and, occasionally, it is not completed.

The QDRO can be used to collateralize a property settlement and protect it from a bankruptcy filing.

QDROs are complex and are written by experts. Those who lack expertise with QDROs are well-advised to seek the advice and services of a QDRO specialist.

Finding an Advisor
If your clients need divorce-related financial advice, please encourage them to consider working with a Certified Divorce Financial Analyst (CDFA®), Certified Financial Planner™ (CFP®), or Certified Public Accountant (CPA) with the Personal Financial Specialist (PFS™) credential. Advisors who hold these designations had to meet rigorous educational, experience, and ethics requirements.

Disclaimer
The author does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Readers should consult their own tax, legal, and accounting advisors before engaging in any transaction.

About the author
Terry Donahe, CFP®, CDFA® is a principal with Springwater Wealth Management, LLC, a fee only registered investment advisor with offices in Oregon and California.
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