How to Protect Your Retirement During Divorce

How to Protect Your Retirement During Divorce

The pain of divorce usually fades. However, committing financial errors when drawing up a divorce settlement can have lifelong consequences. Relying on your attorney to protect you sounds like a good idea, but some financial matters are beyond the capabilities of all but the most knowledgeable divorce lawyers. Your best option is to find a family law attorney with extensive knowledge of personal finance issues.

Most states use the equitable division or equitable distribution standard to apportion marital property during a divorce. Equitable distribution does not mean simply allocating assets equally to each spouse - a 50-50 split - but evaluates the proposed long-term financial situation of each spouse. In many instances, retirement plans are one of the biggest assets in a marriage. Dividing them equitably can be challenging, and if it is not done correctly, one party may end up with far less than he or she expected.

Retirement benefits and accounts take many forms. Pensions (including military pensions), veterans benefits, IRAs, Roth IRAs, Keogh plans, deferred compensation plans, stock options (ESOPS), annuities, and 401(k), 403(k), 457 and 403(b) plans must be considered when dividing marital property during divorce.

Common mistakes when dealing with these assets include:

1. Not categorizing retirement plans correctly: The law deals with different types of plans differently. Not understanding the differences can significantly affect the outcome. For example, some plans, referred to as "qualified" plans, can be divided only with a particular type of court order, called a Qualified Domestic Relations Order (QDRO). Nonqualified plans can be divided using an ordinary court order.

2. Rolling over IRAs directly to the beneficiary: IRA rollovers should be paid to the trustee of the recipient's IRA rather than directly to the spouse or ex-spouse. Otherwise, he or she could unwittingly assume a significant tax liability.

3. Not executing the documents correctly: Retirement plan administrators are the final arbiters of whether documents have been executed correctly. If they find errors, transfers could be delayed or tax penalties incurred. For example, if a QDRO describes a 401(k) as a pension, the request could be invalidated.

The biggest mistake is when QDROs or other court orders contain language that lists specific amounts of money. For example, when an order states that the receiving party is to receive $50,000 from an IRA or 401(k), what happens when the stock market goes down or up? One party might be denied the benefit of a stock market increase, or the other party might have to pay out of pocket to reach $50,000 during an economic downtown.

4. Taking early distributions from a plan: A spouse who takes early distributions from his or her retirement plan - for whatever reason - may be startled when a tax bill comes in the mail.

5. Missing the opportunity to avoid the 10 percent penalty: If the receiving spouse under age 59½ takes a cash settlement rather than a rollover, there are still ways to avoid a penalty. Setting up the settlement as an annuity over the person's lifetime can avoid the 10 percent penalty on early distributions of IRAs.

6. Selecting the wrong retirement assets to transfer: For example, it usually makes sense to select qualified plans such as pension plans and 401(k) plans to transfer to the other spouse. These are usually exempt from the 10 percent penalty (if the spouse is under 59½). Selecting an IRA would incur unnecessary costs.

6. Not changing the beneficiaries and surviving spouse designations on retirement assets: Even when the asset transfers are performed correctly, there may be some unpleasant surprises later if the spouse who owns the retirement plans remarries and does not change designations and beneficiaries.

It is important to avoid these errors during divorce. However, the most common mistake is assuming that everything will work out and ignoring the complexities of retirement plan division. Doing nothing is not an option.