Preparing for the Effect Divorce Can Have on Your Retirement Savings
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Family and relationship issues, increased financial obligations, moving to a new home, and divorce are major life events that trigger stress. Divorce often exacerbates the former stressors; all the more reason to prepare carefully for the financial aspects of divorce, including the havoc it can wreak upon your retirement savings.
Here are a few things to consider regarding how divorce is likely to impact your retirement savings:
Divorcing spouses have a right to Social Security benefits.
Even if you have your own retirement savings accounts, a share of your former spouse’s Social Security benefits could provide you with an additional source of income during retirement. This is particularly relevant if the divorce occurs later in your career, or if you were a stay-at-home spouse during the marriage.
As a divorced spouse married for 10 or more years, you would be entitled to receive 50% of your former spouse’s Social Security retirement benefits, starting at the of age 62, should the following apply:
- You are unmarried when you make the claim
- You have been divorced for at least two years, and
- The benefit you would receive based on your own work history is less than what your spouse would receive at full retirement age
You should note that your share of your former spouse’s Social Security benefit does not affect the amount of benefits he or she receives — it does not “cost” your former spouse anything.
Read more about Social Security benefits for divorced spouses.
Retirement accounts are considered marital assets and are subject to division during a divorce.
If you and your spouse currently have a 401(k), 403(b)an IRA or other defined contribution retirement accounts that were acquired during the marriage, those balances are marital property and subject to division. Negotiating the division of assets in an employer plan will require the help of an administrator, who will require several items before releasing funds from the plan.
First, the administrator will need a Qualified Domestic Relations Order. By law, the domestic relations order (DRO) must state who the assets are to be paid to and in what amount in order to be qualified. The language in the DRO (also known as the divorce decree) must describe the amount being awarded to the alternate payee (former spouse) and be as specific as possible in identifying which assets are to be divided. A DRO lacking clarity or specificity will likely need to be amended or be rejected outright by the administrator. Having the court amend the DRO will not only delay the process but may also be costly.
In the case of IRAs, it is the responsibility of the financial institution to determine if there’s enough information on the DRO before distributing assets.
Some examples of situations that require the DRO to be amended are:
- The amount listed on the DRO cannot be distributed because of a market drop on the investments. There may not be enough funds to distribute.
- The DRO states a certain percentage of the plan is to be awarded to the alternate payee, but if there are 25 assets in the plan for example, does not specify which of the 25 assets within the plan should be divided.
- Assets stated are illiquid and needs to be appraised. Who pays the cost of the appraisal?
States that abide marital or community property laws dictate that only assets acquired after marriage are subject to the divorce decree. However, it is these kinds of legal variations that differ from state to state that can make certain documents, such as prenuptial agreements, so helpful in divorce situations.
If you started saving for retirement before you got married, the funds in that IRA are typically treated as your separate property. If you continued to contribute to the same IRA after marriage, the funds contributed and its earnings after marriage are considered marital assets and are subject to division. This complicates the calculations, but a legal or financial advisor can help you.
Maintain the tax-advantaged status of your retirement savings while you divide them.
Talk with your attorney about what you can do to protect the tax-advantaged status of your retirement assets during division while remaining legally compliant.
These two methods are the most common:
Method #1: Transfers incident to divorce
This method is used to divide assets held in IRAs. Using a transfer incident to divorce allows the alternate payee to characterize the movement of funds as a transfer from the IRA holder to the alternate payee’s own IRA, or a sub account earmarked for the alternate payee. The alternate payee will need to go to the financial institution where the IRA is located in order to implement the aforementioned strategy. The financial institution will validate the DRO presented by the alternate payee and separate the assets from the IRA as the alternate payee instructs.
In this scenario, the spouse receiving the assets is responsible for any tax consequences unless otherwise specified in the DRO. The instructions for a transfer incident to divorce need to meet the standards of both the sending and receiving IRA custodians, and applicable state law. This is an important conversation to have with your attorney and IRA custodian.
Method #2: Qualified domestic relations orders
These are used to divide assets in 401(k)s and similar plans governed by ERISA. A QDRO is a DRO related to divorce, child or spousal support that instructs a spouse’s 401(k) administrator to pay out a share of the plan or account assets. QDROs allow for the plan administrator to segregate the assets of the plan payable to an alternate payee. The alternate payee has the option of leaving the assets in the plan, or as is the case in most plans, of directly rolling over the assets to their own IRA.
Taxation of amounts payable from the plan will depend on who the alternate payee is: if the alternate payee is an ex-spouse, it will be taxed on the distribution; if its paid to a child of the plan participant, the plan participant will be taxed on the distribution and not the child.
The spouse who receives the QDRO assets may roll them into his or her own qualified plan or into a Traditional IRA. (If the assets are rolled into a Roth IRA, the transfer will be taxed as a conversion, but without any penalty.) Rollovers from a qualified plan pursuant to a divorce settlement that is not deemed a QDRO by the IRS are subject to tax and penalty. Be sure your attorney is aware of the specific requirements of QDROs.
Reaching an equitable split can mean balancing out your assets.
Divorcing spouses often mix and match assets to achieve a 50/50 or equitable split. For example, one spouse may choose to stay in the family home in exchange for giving up a larger share of the couple’s retirement assets. However, such negotiations can have long-term consequences.
A house, for example, may not appreciate as quickly as assets held in a retirement account. Plus, there are property taxes and home maintenance to be paid over time. On the other hand, having a house for your family is an important consideration as well. Be sure to think about both the immediate and long-term implications during your negotiations.
Update your beneficiary designations.
Chances are your spouse is listed as beneficiary on your IRA accounts, life insurance, and other accounts. Unless your divorce decree requires you to maintain those designations, be sure to look into updating those documents.
Work with a financial planner or advisor and keep your retirement savings on track.
Many people are left with higher monthly expenses after a divorce. You may not be able to save as much for retirement as you were previously. However, not saving as much isn’t the same thing as not saving at all. Take a hard look at your budget to identify as many unnecessary expenses as possible and minimize accordingly.
Your previous retirement planning was for two; with divorce, your plan will need updating. Take advantage of retirement planning tools to calculate how much money you will need during retirement. If you are age 50 or older, and have the resources, now is the time to take advantage of the “catch-up” provisions that allow you to make bigger contributions to your 401(k), 403(b), or IRA savings plan — up to an extra $6,000 per year for the 401(k) or 403(b), and an extra $1,000 per year for an IRA.
Divorce is challenging enough without stressing over your retirement savings. Fortunately, with proper planning you can mitigate any long-term damage to your hard-earned retirement dollars.
The Entrust Group is committed to improving self-directed investors’ knowledge and helping you learn about potentially life altering events that can have an impact to your retirement savings.