On the list of life’s stressful events, divorce will usually appear as one of the top two or three. And why wouldn’t it? Divorce will likely mean convoluted finances, altered living arrangements for you and your family, and a host of emotions that you will be dealing with, whether they come from you or a loved one. These and several other side-effects of breaking up will cause their share of stress. One of the financial aspects that many couples do not think about is what a divorce will do to their Self-Directed IRA. Here are a few things to consider:
Retirement accounts will be divided up during a divorce
Funds in a defined contribution plan—IRA, 401(k), 403(b)–that were acquired during the marriage are marital property and must be divided. An administrator typically handles the division of assets in an employer plan and will require a Domestic Relations Order (DRO) before releasing funds.
According to the law, the DRO must indicate to whom the assets are to be paid and the amount. It should be specific and clear as to which assets are to be divided, or it could be rejected and sent back to be amended. With a Self-Directed IRA, the financial institution that holds it will be responsible for deciding if the DRO has sufficient information to distribute the funds.
Here are three scenarios which could require amending the DRO:
- The assets that are on the DRO are illiquid and must be appraised.
- The amount stated on the DRO is inaccurate because of a drop in the market, leaving too few funds to be distributed.
- The DRO states that a percentage of the plan is to be awarded to the spouse, but there are multiple assets in the plan, and the DRO does not specify which of these should be divided.
In states with community property laws, only assets that were acquired after marriage are subject to the DRO. Here, an individual who started saving for retirement before getting married would have Self-Directed IRA funds treated as separate property. Any funds that were added after the marriage, including any earnings from them, are considered to be marital assets and subject to being divided. While this is a bit more complicated, a financial advisor can sort it out for you.
How to keep the tax-advantaged status of your retirement funds
Your attorney can help you protect the tax-advantaged status of your retirement assets during division. There are two conventional methods for achieving this while remaining legally compliant:
- Transfers incident to divorce
A transfer incident to divorce allows the alternate payee (often a spouse) to characterize the movement of funds as a transfer from the Self-Directed IRA holder to the payee’s IRA, or a sub-account earmarked for the alternate payee. The payee will need to show the DRO to the financial institution where the Self-Directed IRA is located, at which point the assets can be divided and transferred to the alternate payee.
Unless otherwise stated in the DRO, the spouse receiving the assets will be responsible for any taxes owed. Since the instructions for a transfer incident to divorce must meet state laws and the standards of both the sending and receiving Self-Directed IRA custodians, it’s best to consult with your attorney on the transfer.
- Qualified domestic relations orders
QDROs are used to divide assets in a 401(k) and similar plans covered by ERISA. A QDRO is a DRO related to divorce, child, or spousal support. It instructs the spouse’s 401(k) administrator to pay out a portion of the plan’s assets and allows the plan administrator to set apart those assets that are payable to an alternate payee. Alternate payees may then roll over those assets directly into their Self-Directed IRA or their qualified plan.
When the alternate payee is a spouse or former spouse, they will owe taxes on the distribution if they choose not to do a rollover. If the payee is a child of the plan participant, the plan participant will be taxed. Rollovers from a qualified plan in a divorce settlement must be deemed a QDRO by the IRS, or they will be subject to tax and penalty. Inform your attorney of the specific requirements of the QDRO.
You might have to juggle assets to achieve a fair split
Divorcing couples sometimes mix and match assets to make an equitable division. But there are a host of considerations in the process. One spouse might give up a significant share of the retirement assets to be able to stay in the family home, but those assets may have better long-term growth prospects than the appreciation in the value of the house.
Once again, talk to your financial advisor or attorney to make sure you are weighing both the short-term and long-term consequences of your decision.