Strategies for Tax Free Divisions of Retirement Benefits
- z85285
- May 28
- 5 min read
Hoffman & Van Clief LLP
QDROs | Valuations | Equity Compensation
Strategies for Tax Free Divisions of Retirement Benefits
by: Alex Hoffman and Elizabeth Van Clief
As a family law attorney in Colorado, it may be your standard practice to look for ways to offset retirement assets against other large assets such as a house, cash, or spousal support to try to avoid the transaction of dividing retirement assets in divorce. You might be concerned that dividing a retirement plan will cause one or both of the parties to incur taxes, penalties, or result in inequities between the parties based on tax attributes.
Fortunately, almost every type of retirement asset has a relatively easy and tax efficient way of being divided. Here is a brief discussion of the common types of retirement assets and the tax aspects associated with dividing these plans and accounts in divorce.
Traditional Individual Retirement Accounts (IRAs).
Traditional IRAs are pre-tax retirement accounts that are normally invested in stocks, bonds, and cash within the IRA. When a withdrawal is made from an IRA, it is taxed at the recipient’s ordinary income tax rate. If the recipient is under age 59 ½, the IRS also assesses a 10% early withdrawal penalty that applies to the withdrawal. Therefore, IRAs are normally thought of as long-term investment accounts that are 100% pre-tax and which should be taken out slowly in retirement starting at age 60 or later. In divorce, an IRA can be divided proportionately between the parties without incurring income taxes or the early withdrawal tax penalty pursuant to IRC section 408(d)(6).
To accomplish a tax-free division of an IRA in divorce, a Domestic Relations Order (“DRO”) or Settlement Agreement needs to contain the correct language to divide the IRA, and the parties need to present the Divorce Decree, DRO or Settlement Agreement, and a divorce transfer form to the IRA bank to accomplish the transfer. The spouse receiving IRA benefits receives the assets in a Traditional IRA and they are still held 100% pre-tax by the recipient spouse. So, no taxes are incurred on the transfer, both parties divide the IRA assets proportionately, and both parties receive the IRA assets pre-tax which means each party will recognize their own taxes on the IRA assets in the future when they choose to take out the IRA benefits.
401(k) and other Defined Contribution Plans.
Defined contribution plans traditionally only hold pre-tax retirement benefits in the plan invested in stocks, bonds, and money market investments within the plan. Many plans have restrictions on when benefits can be taken out of defined contribution plans which are intended to prevent participants from withdrawing retirement benefits while still employed. Similar to IRAs, any withdrawal from a defined contribution plan will incur ordinary income taxes and an early withdrawal penalty of 10% if the withdrawal is made before the age of 59 1/2. If funds are needed during employment or before age 59 ½, most plans allow for a tax-free loan from the defined contribution plan which allows for retirement investments to be sold, distributed to the participant, and then the participant pays themselves back plus interest (rather than paying a third party bank interest).
To accomplish a tax-free division of a defined contribution plan in divorce, a Qualified Domestic Relations Order(“QDRO”) can be prepared. A QDRO allows for the parties to proportionately divide the retirement assets and allocate them to the recipient spouse on a pre-tax basis. Once the QDRO is processed by the plan administrator, the recipient spouse receives their assets within the plan in a subaccount in the recipient spouse’s name, waiting for the recipient spouse to complete a distribution form. Interestingly, the QDRO division of a defined contribution plan allows for many more tax and distribution options than a traditional IRA. The most common options for distribution under a defined contribution QDRO are as follows:
The first option is the recipient spouse can receive a tax-free rollover of benefits into another IRA or defined contribution plan. This method incurs no taxes and allows for the pre-tax retirement benefits to stay as pre-tax retirement benefits until a distribution is requested in the future.
The second option is the recipient spouse can cash out the benefits directly from the defined contribution plan pursuant to the QDRO and receive a check in cash. This distribution is taxable at the recipient spouse’s ordinary income tax bracket, but IRC section 72(t)(2)(c) provides for an exception to the early withdrawal penalty so that the normal 10% early withdrawal penalty does not apply to the cash distribution.
The third option is to take a partial tax-free rollover and partial cash out. The benefits that are cashed out are subject to ordinary income taxes (and not subject to the early withdrawal penalty), while the benefits that are rolled over into an IRA are transferred tax-free as 100% pre-tax assets.
The fourth option is to leave the benefits in the plan and delay the decision about whether to receive a distribution under options a, b or c (above).
Pension Plans / Defined Benefit Plans.
Pension plans (also referred to as “defined benefit plans”) are retirement plans where the participant does not invest their assets directly, and instead the employer invests a pool of assets and promises to pay the participant monthly benefits based on a formula that involves a multiplier of how long the participant has participated in the pension (i.e. worked for the employer) multiplied by the participant’s salary. Some pension plans also offer a lump sum or periodic payment options, but by far the most common is monthly benefits calculated over the participant’s lifetime. These benefit payments are taxable income to the participant at the participant’s ordinary income tax rate. The participant receives a Form 1099 each year while in pay status.
To accomplish a tax-free division of a defined contribution plan in divorce, a QDRO can be prepared. This allows for the pension plan to pay each spouse their proportionate share of the monthly benefits and each spouse is taxed on their proportionate share upon receipt by receiving completely separate Form 1099s. The division of pension plans in divorce using a QDRO normally allows for significant tax savings to both parties by “splitting” the income between both parties rather than the participant receiving 100% of the payments and being pushed into a higher tax bracket.
Takeaways From This Article
Although there are a variety of different retirement plans that family law attorneys encounter in divorce, all types of retirement plans allow for a tax-efficient method for dividing the marital interest without incurring taxable income. In many cases, dividing retirement benefits in divorce allows for more tax advantageous distribution options than non-divorcing spouses have. Being aware of these distribution options can greatly benefit your clients.
If you have any questions or comments regarding this article, we would love to hear from you. Please e-mail or call us anytime, we would be happy to assist you or your client with preparing a QDROs or answer retirement benefits questions.
If you have any questions about this information, please feel free to call our office at
720-800-8418 or e-mail alex@hvclaw.com and we will be happy to assist!
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