In many divorce cases retirement accounts can constitute the bulk of the marital assets that need to be divided. You worked hard and set money aside so it is natural to have questions about how those assets are handled in a divorce.
Retirement Accounts Can Be Community Property
The same community property rules that apply to other types of property apply to retirement accounts.
This means that there is a presumption that retirement accounts are community property. A spouse claiming that a retirement account is separate property during a divorce must show that it was owned prior to marriage or acquired by inheritance.
To the extent the assets in the account were earned during marriage, they are community property and subject to division during a divorce.
Defined Contribution Accounts vs. Defined Benefit Accounts
There are a number of different types of retirement accounts but they generally fall into one of two types of accounts.
The first type is called a defined contribution account. Defined contribution accounts hold assets that were contributed by a spouse and the value of the account is based on the amount of those contributions as well as any growth in the investments. The most common examples of defined contribution accounts are 401k’s and individual retirement accounts (IRA’s).
The second type of account is a defined benefit account. Defined benefit accounts provide a fixed benefit for a period of time during retirement. The amount of the benefit is usually determined by a formula based on the length of the employee spouse’s employment and the employee spouse’s salary. Pensions are a prime example of a defined benefit account.
What Part of a Defined Contribution Account Is Subject to Division?
Remember – to the extent the contributions to a defined contribution plan were made during marriage, those contributions are community property. Any increase in the value of the account during marriage is also community property.
If all of the contributions occurred during marriage, then the entire account is community property and subject to division in your divorce.
But what if you started contributing to the account before you were married?
In that case, you would take the current value of the account and deduct the balance on the date of your marriage to determine what portion of the account is community property and subject to division.
However, there is a presumption that all assets owned by the spouses are community property. So the spouse claiming that a portion of the account is separate property has the burden of establishing the value of the account prior to marriage.
What Part of a Defined Benefit Plan is Subject to Division?
Dividing defined benefit plans in a divorce is more complicated.
To the extent that all of the employee’s credit under the plan was earned through employment during the marriage, the entire benefit is subject to a just and right division during divorce as of the time of divorce. More on that later.
If some of the employee’s credit in qualifying for benefits under the plan was earned through employment prior to marriage, then there is a formula to determine what portion of the benefit is community property and subject to division.
You take the total number of months the employee spouse worked and earned credit during the marriage then divide that by the total number of months the employee spouse worked and earned credit. This gives you the percentage of the benefit that is subject to a just and right division during divorce as of the time of divorce.
The actual benefit the employee spouse is entitled to under this type of plan is usually determined by some formula involving years of service and salary. In addition, at the time of divorce, the employee spouse’s right to receive benefits may not be fully vested but the plan is subject to division regardless.
There are other issues that complicate the division of defined benefit plans as well.
For example, the divorce may be years before any actual payments are due under the retirement plan. In this case the community value of the benefits may need to be discounted to its present value.
In addition, any increase in the benefit’s the employee spouse will receive that is attributable to that spouse’s employment after divorce is his or her separate property and not subject to division. This is why the non-employee spouse’s interest is determined at the time of the divorce.
The Process of Dividing Retirement Plans
The process of dividing retirement plans in a divorce varies depending on the specific plan. That is why it is important to have copies of the plan documents available during your divorce.
For example, dividing an IRA during a divorce can usually be accomplished in one of two ways. The first is to “cash out” the account and divide it in accordance with the divorce decree.
Unfortunately, that will result in a significant tax hit unless the account is a Roth IRA. The better alternative is to divide the account and roll over the other spouse’s portion into a new IRA.
While the “cash out” option is available for 401ks, the same penalties and taxes that affect IRA’s apply. The better option for 401ks (and required option for many other retirement accounts) is to use a Qualified Domestic Relations Order (“QDRO”).
In some cases, defined benefit plans will allow for the non-employee spouse to receive a lump sum payout. In other cases, the non-employee spouse will not receive benefits under the plan until his or her spouse begins receiving benefits.
What is a QDRO?
A Qualified Domestic Relations Order is a type of order issued separate from the final decree of divorce that specifically addresses the division of certain types of retirement accounts.
The biggest benefit of a QDRO is that it allows the tax-free division of the retirement account without penalty.
This means that instead of “cashing out” a 401k then paying penalties and taxes, the account can be divided into a separate 401k for each spouse without any taxes being due.
Other Types of Retirement Accounts
While 401k’s and IRA’s are the most common types of retirement accounts that will be divided during a divorce, there are a number of other types of retirement accounts.
Below is a list of various types of retirement accounts that could be community property and subject to division during a divorce:
- Military Retirement Pay
- Civil Service Retirement
- Railroad Retirement
- Police Officers Pension
- Employees Retirement System of Texas
- Teachers Retirement System of Texas
- Texas County and District Retirement System
- Texas Municipal Retirement System
Each has its own rules and requirements for dividing the account.
Social Security Benefits Are Not Subject to Division
While most people think of social security benefits as a retirement benefit, social security income is not subject to division in a divorce.
This is because the Social Security Act preempts state law and overrides the community property laws of the State of Texas.
Buyouts and Offsets
As you can see above, the process of valuing and dividing certain types of retirement accounts can be very complicated. There are also additional costs involved in drafting QDROs or other documents.
As a result, parties may look to alternatives methods of dividing property in order to avoid the division of retirement accounts. Two common examples are buyouts and offsets.
A buyout is similar to a cashing out a plan. The non-employee spouse receives a cash payment in lieu of dividing the retirement account.
To the extent there is sufficient cash in other property, that buyout can be paid without having to allocate any penalties or taxes resulting from an early withdrawal from the retirement account.
If there is sufficient other property in the marriage, the spouses may agree to an offset. In this case, the non-employee spouse will receive additional property in the divorce from another source to offset their interest in the retirement account instead of actually dividing the account.
Updating Beneficiary Designations
The importance of updating the beneficiary designations on your retirement accounts cannot be understated.
Beneficiary designations on certain types of accounts that designate a former spouse are automatically revoked. But you should not rely on this and instead should make those changes immediately upon your divorce.
The reason is that certain types of accounts (particularly those governed by ERISA) are governed by federal law that preempts state law. This means that a beneficiary designation in favor of your former spouse will be enforced and he or she will receive the balance of the account if you pass away.