Divorce, Retirement Accounts, & Taxes
Divorce has a tremendous impact on your finances for years to come, and property division is a big (in many cases the biggest!) piece of that equation. Plus, the majority of many Americans’ savings are held in tax-advantaged retirement accounts like 401ks, IRAs, Roth IRAs, etc. So, you very well may find that the majority of the accounts that we are dividing in your divorce are retirement assets.
With retirement accounts’ many tax advantages come special rules that need to be carefully followed. It’s important to understand the basics of taxes, retirement accounts, and divorce so that you can make informed decisions that move you toward the life you want to live post-divorce.
Read on to learn answers to the biggest questions.
Do I Have to Pay Tax on Retirement Accounts Divided in Divorce?
Divorce courts have the authority to divide property including retirement accounts. And, there are ways to do it that avoid taxes (and penalties). How this is accomplished depends on whether your retirement account is connected with your employer (like a 401k or a pension) or independent (like an IRA).
401ks and Pensions
Generally speaking, if you are splitting a 401(k), pension, or other qualified plan you will need to obtain a QDRO in order to access the funds without incurring a tax penalty. QDROs only apply to plans covered by ERISA. Simply making a withdrawal from such a plan following divorce would trigger a tax event, including possibly a 10% penalty. A QDRO avoids this problem. You need to make sure this is done correctly — as your divorce attorney we will help you coordinate with your QDRO attorney.
IRAs and Roth IRAs are divided using a process known as “transfer incident to divorce.” As with a QDRO and qualified accounts, if the transfer incident to divorce is executed properly, no tax will be assessed on the transaction.
What if I Want to Withdraw Money Transferred to Me Via QDRO?
Many people believe – mistakenly – that taking distributions from retirement assets prior to age 59 always results in a 10% penalty tax.
But the tax code also provides that money being transferred under a QDRO associated with a divorce can go directly to the recipient spouse without being subject to the 10% penalty tax. Note that this only avoids the 10% penalty tax for early withdrawal. The money withdrawn is taxable the year it is withdrawn and there is no way around that.
It’s critical that this be done properly in order to qualify to avoid the 10% penalty. Contact us so we can point you in the right direction.
Can I Withdraw Retirement Funds to Pay Attorneys’ Fees?
We now know that you can separate retirement accounts without triggering a taxable event. We also know that you can access that money to spend without paying the 10% penalty regardless of your age.
But what if you want to access retirement funds during the divorce to pay your divorce attorneys’ fees, including funding your retainer, and you do not want to pay the 10% penalty? Although you can’t withdraw funds during a divorce and avoid the 10% penalty like you can as part of the property division in a divorce, there are two alternatives to consider. They are:
- 401k Loan
- Roth IRA Contribution Withdrawal
401k Loan for Divorce Legal Fees
First up, one option is to take a loan from your 401k in order to pay your divorce attorneys’ fees. Many 401ks allow for loans that do not trigger a 10% penalty. Investigate whether you can take a loan from your 401k rather than making a withdrawal.
Roth IRA Withdrawals for Divorce Attorney Fees
There are a lot of terrific things about Roth IRAs. If you’re eligible for a Roth, you don’t get a deduction for Roth contributions. But, when you start withdrawing funds after 59½, everything — including the growth — is tax-free.
So, a Roth IRA is a great way to save funds without worrying about taxation in the future.
The Roth has an additional, relatively little-known benefit for divorce clients who only have retirement funds, and need access to money to fund their divorce.
If you are under 59½, you may withdraw from your Roth the exact amount of your contributions with no penalties. (And since with a Roth you have already paid tax on those contributions, you don’t pay any more tax when you withdraw them.)
One important caution: do not withdraw any funds from your Roth before speaking with your divorce attorney. You’re allowed to use funds to pay reasonable attorneys’ fees under Connecticut’s Automatic Court Orders. But like all of this, you have to do it the right way to avoid serious consequences.
That may have been more than you ever thought you wanted to know about retirement accounts and taxes. But you did it, and now can have informed discussions with your divorce attorney, your QDRO attorney, your tax professional, your financial professional, your neighbor, your kids’ teacher, your favorite restaurant server — you get the picture. More importantly, you know what you need to know to make the right decisions on retirement accounts during your divorce. Decisions that can and will move you toward the life you want to live.
Our first step at Freed Marcroft, the Goals & Planning Conference, is designed to get to the heart of your problem and unveil your true goals. Then, we take those goals along with the facts of your case and analyze them so that we can present you with recommendations and options on how to move forward.