What Happens to Your 401k in a Divorce?
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A divorce can be messy.
It can be especially messy if one spouse has a hefty 401(k) or other retirement account, and the other has racked up a lot of debt.
But what are the odds of getting divorced? After all, your marriage is great and you’re in love. Or so you think.
While divorce rates have been trending downward especially among younger couples since 2008, according to a study by the American Sociological Association, first marriages don’t always end so well overall.
A marital and family studies expert told ABC News that a rough estimate of the overall divorce rate of first marriages is 40-42%. That may be all you need to know to get at least thinking about how your retirement fund and other retirement assets would be divided in a divorce and how your partner’s debt might be resolved.
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Your retirement account
Remember your wedding vows? There was likely something about “for richer, for poorer” and “till death do us part.”
A divorce gets you out of staying together until you die, but a judge will decide how the richer and poorer parts will be divided. The divorce proceedings aren’t easy and aren’t cheap either. You need to separate property, deal with income taxes, and think of dividing your bank accounts.
Generally, what you brought into a marriage will remain yours upon divorce. Unless you have a prenuptial agreement that says your retirement account is all yours, your spouse will likely have some claim on it. Laws differ by state, so these are general guidelines for marital property division.
If you opened a retirement account after getting married, it’s marital property. If the account was opened before you got married but contributed money to it during the marriage, then some of the assets are marital property.
A judge will decide how to divide the account based on how much of the retirement fund was paid during the marriage. Only the marital portion of the account will be divided. What you contributed and the account's earnings, before you got married, should remain yours.
If you live in a community property state, the spouse is entitled to 50% of marital assets. In common-law states, the split doesn’t have to be made down the middle, but it has to be fair.
New York is a common law property state that follows equitable distribution laws. The common law property system states that property acquired by one person belongs solely to that person unless it is specifically put in the names of both spouses.
Assets are divided “fairly” by a judge who considers factors such as the duration of the marriage, career opportunities given up, and the ability of each person to support themselves.
Another large state, California, follows community property laws that divide the couple’s joint assets in half. Factors such as the length of marriage and number of children aren’t considered when dividing assets.
To avoid IRS penalties for early withdrawals from retirement accounts, money can be rolled over from your account into your ex-spouse’s. Writing a check is considered a regular withdrawal and could be taxed. A divorce lawyer can guide you in the right direction here.
Related: How To Make The Most Of Your 401(k)
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A qualified domestic relations order
Retirement savings can be the largest and most valuable asset in a marriage. A Qualified Domestic Relations Order, or QDRO, can help distribute the funds equally without tax penalties in a divorce.
A QDRO is a court order that can instruct your spouse’s pension or retirement plan on paying your share of plan benefits. It applies to defined contribution plan assets such as 401(k)s, but it doesn’t need to be divided into IRA or SEP assets.
It is separate from a marital settlement agreement. A QDRO allows retirement plan funds to be separated, withdrawn without penalty, and deposited into the non-employee spouse’s retirement account. The order must be approved by the retirement plan’s administrator and the court.
The IRS allows cashing out a retirement fund under a QDRO, and it won’t be subjected to a 10% penalty for early withdrawal before age 59.5. However, the money taken out now will be taxed as regular income.
Tax Implications
A 401(k) is often one of the most significant assets in a divorce and is subject to specific rules and procedures. When a QDRO is used, funds can be transferred from the 401(k) to the ex-spouse's retirement account (e.g., IRA) without incurring early withdrawal penalties or immediate taxes. The receiving ex-spouse will owe taxes upon future withdrawals from their retirement account, not at the transfer time.
If the 401(k) funds are transferred to the ex-spouse via a QDRO, the original account holder is not taxed or penalized at the transfer time. The balance of the account holder’s 401(k) is simply reduced by the amount transferred.
If the ex-spouse rolls over the funds into an IRA or another qualified retirement plan, they will not face immediate taxes or penalties. Taxes will be due upon future withdrawals based on the ex-spouse’s tax situation at the withdrawal time.
Suppose the ex-spouse takes a cash distribution instead of rolling the funds into another retirement account. In that case, they may be subject to a 10% early withdrawal penalty if they are under age 59½, in addition to regular income taxes on the amount withdrawn.
However, if the distribution is part of a QDRO, the 10% early withdrawal penalty can be avoided, although the amount will still be subject to regular income taxes.
Both parties must consult with a tax professional or financial advisor during the divorce process to understand the tax implications and to ensure the QDRO is correctly drafted and executed. State laws vary, so local regulations may affect the division and taxation of retirement accounts.
What about debts?
Another potential downside in a divorce is if you’re a saver and your spouse is a spender, what do you do about their debts?
The same caveats that applied to assets apply to debts. Laws vary by state, with some states accounting for the assets and debts each person brought into a marriage.
In community property states, everything is owned equally. It doesn’t matter who created the debts. A prenuptial agreement could address debts, putting them solely on the person who caused them.
Debts include much more than just credit card balances that have piled up. They can be any bill that arrives at your house and don’t have to be long-term debts. If you’re living at your house but your spouse isn’t after a divorce, the garbage, electricity, water, and other bills still have to be paid.
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Who pays credit card debts?
Let’s assume you’re paying those bills. What about debts such as unpaid credit cards that a collection agency or creditor is after?
If the credit card was in both of your names, you should have the payments in the divorce agreement. Once the balance is paid, you may want to cancel the card or remove one person’s name.
If the divorce agreement isn’t followed and a spouse doesn’t make the payment, you can ask the court to enforce it and require your spouse to appear to explain why it isn’t being followed.
If a credit card is in one person’s name, they should be responsible for paying the bill. However, a judge may decide that if you charged the card when you were married, you’re responsible for at least half of the charges.
Also, credit card companies may seek payment from you even though your name wasn’t on the card. As a former spouse, they may consider you liable for payments.
You should expect to be held liable for debt in your name. You’ll be jointly liable for credit card debt taken out in both names.
Even if you aren’t contractually liable for your former spouse’s credit card debt, a judge may order you to pay part of it. For instance, anything you bought with a credit card to run a household could be a debt for both spouses.
A divorce decree isn't enough
A divorce decree ordering your spouse to pay your debt doesn’t cancel your contract with the credit card issuer. Showing your divorce decree to a creditor won’t erase your liability for the debt.
If the credit card is in your name and your ex doesn’t pay the debt as ordered by a judge, your best recourse may be to pursue them in court.
Another solution is to remove your name from those credit accounts. If you owe money, a creditor is unlikely to remove your name, even if someone else is legally ordered to pay the debt. One option is for the spouse responsible for the payment to transfer the balance to a card in their name only with a balance transfer.
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A little good news
There is one small bit of good news in all of this. Your credit history and credit score won’t change because of a divorce.
They are only yours and will always be yours alone. They didn’t change when you got married, and they didn’t change when you got divorced.
Late payments on an account that you’re an authorized user on can affect your credit score if your ex-spouse isn’t paying the credit card bill. To avoid that, remove yourself as an authorized user or close joint credit card accounts.
The debts you create after a divorce are now solely yours. Your former spouse’s name on an account could only add to your problems.
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FAQs
Are there immediate tax consequences when dividing a 401(k)?
No, there are no immediate tax consequences if the funds are transferred to the ex-spouse’s retirement account through a QDRO. Taxes are deferred until the receiving spouse takes distributions.
Can the receiving spouse take a cash distribution from the 401(k)?
Yes, but if the receiving spouse opts for a cash out, they will owe income taxes on the lump sum amount withdrawn. If they are under 59½, a 10% early withdrawal penalty may also apply.
Can the funds be rolled over into another retirement account?
Yes, the ex-spouse can roll over the funds into their own IRA or another qualified retirement account, avoiding immediate taxes and penalties.
Can the division of a 401(k) be negotiated in a divorce settlement?
Yes, spouses can negotiate the division of a 401(k) as part of their overall divorce settlement, possibly offsetting the 401(k) with other marital assets to achieve an equitable distribution.
The bottom line
Divorce isn't easy, and dividing your assets isn't either. A 401(k) can be divided without immediate tax consequences or penalties by using a Qualified Domestic Relations Order (QDRO). The ex-spouse can roll over their share into an IRA or another retirement account, deferring taxes until they withdraw. If the ex-spouse takes a cash distribution instead, they will owe income taxes and potentially a 10% early withdrawal penalty if under 59½. Consulting a tax professional is advisable to navigate the specific details and ensure compliance with tax laws.
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Writer
Aaron Crowe is a freelance journalist who specializes in personal finance writing and editing. He has worked at newspapers, where he won a Pulitzer Prize, and has written for numerous online publications. These include AOL, US News & World Report, WiseBread, Bankrate, AARP, and many websites focusing on housing, credit and insurance. He lives in California with his wife and daughter.
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