It is quite common for retirement to be one of the most valuable assets held by divorcing couples. Any retirement interest accumulated from the date the couple marries, until the date they separate is considered community property and each spouse is entitled to one-half of the accumulation. Today’s blog focuses on types of retirement, how to determine value, distinguishing community versus separate interests in retirement, and how retirement interests are divided.
Types of Retirement. The two main types of retirement are Defined Benefit Plans and Defined Contribution Plans. Defined Benefit Plans are typically pension plans where upon the retirement of the vested spouse, they receive a monthly annuity payment for the course of their lifetime which is based on a multiplier considering years of employment and salary. The employee spouse does not pay into the retirement which is instead based upon longevity. A Defined Contribution Plan, on the other hand, is a benefit based upon contributions made to the plan by the Employee and/or Employee which in turn is invested within the Plan. Typical examples of Defined Contribution Plans are 401(k)’s, IRA’s, 403(b)’s, Profit Sharing Plans and 457 Plans.
Determining Value With a Defined Contribution Plan the employee spouse can obtain an account statement that shows the amount of money in the retirement account. It is important to note that there are restrictions to accessing these funds. Except for Roth IRA accounts which are not taxed at distribution, the money held in these retirement accounts are pre-tax dollars and will need to be reported as income when they are distributed. If you seek to access these funds before age 59 ½ then additional penalties apply for early distributions. A current statement from the Plan will give a current value subject to these tax and early distribution issues.
With a Defined Benefit Plan determining value is more difficult. Let’s take a Navy Pension as an example. In our scenario, the retired service member will receive an annuity of $2,800 for their lifetime. At time of retirement they can either opt for survivor benefits which will reduce the monthly annuity to secure a survivor annuity that will continue to be paid (such as 50% of annuity amount) to the designated beneficiary. For our example let’s say no survivor benefit was chosen. The value of the pension in this case will be $2,800 a month times the number of months that the annuitant lives. The value of the benefit can vary greatly depending on if the life span is 1 year or 30. There are companies that will place a value upon a pension considering life expectancy tables, etc. but the valuations are speculative compared with the hard numbers that a Defined Contribution Plan has.
Community Versus Separate Interest A common issue encountered with retirement division, is when a spouse makes contributions toward their retirement before marriage. For Defined Contribution Plans the contributions made by the spouse up to the date of marriage, and any gains/losses on these funds during marriage are the separate property of that spouse. Any contributions made during marriage (by either the employee or employer) and any gains/losses on these funds are considered community. There are professionals that can be hired who specialize in doing the calculations to assess the separate versus community interest in these retirement plans.
For Defined Benefit Plans we have what is called the Time Rule to determine the separate versus community interest. Let’s go back to the Navy pension example. The servicemember spends 20 years in the Navy with 12 of those years taking place during the marriage. The 12 years toward retirement during marriage would be considered community and the 8 years before marriage or after separation would be considered separate. The time rule is a fraction where the numerator is the years during marriage and the denominator is the total time toward retirement which equates to the community interest. In this scenario the fraction is 12 over 20 setting the community interest at 60% with the non-retiree spouse’s interest being 30%.
How are Retirement Interests Divided? The Internal Revenue Code allows divorcing couples to transfer retirement interests between themselves incident to divorce. There are very specific rules to be followed but so long as done correctly the transfer will not trigger a taxable event nor will it result in penalties for early withdrawal. To accomplish this transfer of funds typically a special order from the Court, called a Qualified Domestic Relations Order, or QDRO, is required. Because there are significant financial consequences if not done correctly, most attorneys and mediators direct their clients to hire a QDRO Professional to handle the drafting. One exception to the need for a QDRO is when the retirement to be divided is an Individual Retirement Account (IRA). If this is the case, upon meeting certain requirements, an IRA division can be handled in the Marital Settlement Agreement itself.
What About Offsetting Against Other Assets? One way of avoiding the hassle of having QDRO’s drafted to divide retirement is by offsetting the retirement interest against other assets such as the equity in the house, or other investment accounts that do not have the same requirements and restrictions related to division. When making these sorts of decisions it is important to consider that the retirement dollars are pre-tax dollars and there are restrictions on their use or penalties will be incurred. Sometimes the couple might agree to discount the retirement dollars versus other offsetting cash dollars given these limitations. The bigger question might be the consideration of your long term financial health and goals to determine if electing to trade retirement for other assets is in your best interest. It might be very beneficial to sit down with a Certified Divorce Financial Analyst or other financial professional to think through these important decisions.
I have only begun to touch on some of the issues presented when considering the division of retirement at divorce. Making sure that you are in a well educated position to make these important decisions is critical. Working with professionals that understand your options so that you and your spouse can fashion a settlement that helps you both accomplish a practical and healthy solution is the sensible way to approach these sometimes complex issues.