Money is often a key consideration during your divorce process. How you address your finances during divorce has consequences which last a lifetime. One of the most common decisions during divorce is the division of your (and/or your spouse’s) 401k. The process sounds easy enough, but there are some key rules to follow. Best practices should be considered before simply dividing your retirement accounts in half.
Should We Divide the 401k In Half in Our Divorce?
Dividing assets in half does not mean that ALL accounts are divided down the middle. This may sound obvious to the person who is not caught up in the emotions that accompany most divorces. I find it is not so obvious to the couple who is considering divorce. When I first ask a couple how they want to divide assets, dividing all accounts in half is the standard answer. When considering a 401k, this may not be the best solution for many reasons.
Cost of Dividing a 401k Because of Divorce
The division of your 401k (or 403b or 457) account is one piece of your bigger financial picture. Simply dividing your (and perhaps your spouse’s) 401k in half may be the most costly and inefficient option available.
When you divide a 401k (or most other company sponsored retirement plans), you need to complete a Qualified Domestic Relations Order (QDRO). This is a legal document that tells your plan administrator how to divide the assets and that the division is pursuant to a divorce. As a QDRO is a legal document you guessed it – there is typically a cost for a lawyer (or similarly trained professional) to create this document.
Even if you create a simplified form, which is becoming more common on human resource websites, there is typically a fee applied by the human resource department to implement your decision. If you can avoid this cost, yet still reach your desired outcome, I suggest you consider it.
What Are Our Other 401k Options in Divorce?
You may be thinking how else would I get to the desired outcome without dividing each 401k?
Too often couples focus on the weeds rather than on the forest. They neglect ALL the potential tools and focus only on one. As an example, if other accounts are available (IRAs, brokerage accounts or checking/saving accounts), you may want to consider offsetting balances to achieve the same desired overall outcome.
As an example, if you and your spouse each have a 401k AND an IRA account, is there a solution that would include dividing or transferring part of the IRA to offset half the balance of the 401k? I mention an IRA account because for the most part, they have the same tax consequences (excluding a Roth version) so they are good substitutes.
Another reason I mention considering an IRA is that there is no QDRO (or human resource fee) required when transferring an IRA. This solution becomes a more cost effective and efficient solution. In most cases, a copy of the divorce decree, an IRA distribution form and a letter of authorization is all that is needed. Three forms may sound like more work, but they are pretty straightforward and more cost efficient than a QDRO.
What if an IRA account is not available?
When other tax deferred accounts are not available, you may consider using other financial accounts when considering your desired overall outcome. Using accounts with different tax structures may reduce the costs of additional legal documents, however using different account structures becomes more complex due to the fact that you must consider the after tax value of each account.
As an example a dollar in a taxable account is worth a dollar if liquidated and spent. On the other hand a dollar withdrawn from a 401k is treated as income and is taxed at your ordinary income tax rate. In most cases, this means the dollar is worth less than a dollar after taxes. This does not mean you should avoid considering the substitution of other accounts when considering the cost and complexity of dividing a 401k, it simply means you have a few more things to consider in order to achieve the desired overall division of assets.
Benefits of 401k Withdrawal Due to Divorce
The cost and complexity of the division of a 401k in divorce is only one part of the consideration. There are potential benefits to using proceeds from a 401k in divorce. For example, if cash is needed, you may be able to avoid the early withdrawal penalty tax if money is withdrawn as part of the divorce decree and withdrawal is done by use of a QDRO.
There is no perfect or standard answer to dividing 401ks in divorce. However, if you take the time to consider the specifics of your situation, and evaluate all the financial tools available, you may find a better solution for your financial divorce than the one you originally considered.
As a Certified Divorce Financial Analyst, I can help. Please contact me if you have questions about how your 401k divorce decisions will affect your financial life during and after your divorce is finalized. Uninformed decisions can be costly and in most cases, are not reversible. It is best to figure out your options as soon as you are considering divorce.
Bob Burger, CFP®, CDFA®, RMA