When couples divorce, they must decide what to do with the marital residence, they must decide on child custody and visitation, and how to divide their marital assets.
Often, IRAs and 401(k)s come to play, and it's important that these assets are divided carefully and intelligently in order to avoid unnecessary taxes and penalties.
The biggest issue with mishandling a retirement account is taxation. For example, with the funds in an IRA, the funds are usually transferred from one spouse's IRA to their spouse's new or existing IRA.
While this type of transfer in a divorce is not usually considered "taxable," it must be transferred correctly. If the funds in an IRA are not transferred correctly, it will be considered a full distribution and there will be unfavorable tax consequences.
As a general rule, the best way to transfer assets in an IRA is to move them into another one. In this scenario, the spouse will not be taxed when their funds are distributed to the other spouse's IRA, and the receiving spouse will not face any tax consequences either.
Note: such transfers are only tax-free if they are required under a couple's divorce decree, otherwise any such transfer will be taxable.
QDROs for 401(k) Assets
If a spouse has retirement assets in a 401(k), the best way for them to ensure that their retirement funds are distributed properly is by obtaining a qualified domestic relations order, otherwise known as a QDRO.
QDROs are legal documents that divide a person's retirement account with a dependent, a spouse, or an ex-husband or wife. The QDRO allows money inside a 401(k) to be transferred to another individual without imposing the taxes or penalties commonly associated with transfers.
QDROs do not apply to standard IRAs, they apply to the assets held in 401(k) and 403(b) plans. Also, it may be a good idea to transfer the funds in a Roth IRA through a QDRO because it allows spouses to avoid taxes and penalties.
A Lot of Money is at Stake
If you or your spouse have a retirement plan and you're headed for divorce, please be aware that a lot of money could be at stake. In fact, if it's done incorrectly, it's possible to lose almost half the money in a retirement account.
As a side note, don't forget to update your beneficiary designations on your retirement accounts following a divorce. The most surefire way to remove a former spouse from your retirement account is to change the beneficiary listed on the beneficiary designation form.
Make sure your retirement plans are divided correctly – contact Cairns Law Offices today!