What Happens to 401Ks in a Divorce?

Going through a divorce is never an easy or fun situation. Divorces tend to be messy and confusing. They are seldom straightforward. Aside from the emotional toll a divorce can take on the parties involved, it can also take a heavy financial toll. In the United States, according to worldpopulationreview.com, somewhere between 35%-50% of first marriages in the United States end in divorce. For second marriages, that percentage jumps up to around 60%. For third marriages and beyond, it rises even further, with more than 70% ending in divorce. If you are considering a divorce from your spouse, you should definitely speak with a qualified divorce lawyer. They will be able to help you understand your rights when it comes to the division of your most valuable assets, including your 401(k).

How Are 401(k) Plan Accounts Split in a Divorce?

So how are 401(k)s split in a divorce? A 401(k) is owned individually rather than jointly, even when it has named beneficiaries associated with it. Though your 401(k) is individually owned by you, and your spouse’s 401(k) is individually owned by them, these are likely to be divided up in some way in the event of a divorce. How your 401(k) is divided will be largely dependent on the state laws where you reside.

Community Property States

“Community property” refers to all assets (or debts) acquired by either spouse during marriage. In community property states, any asset acquired by either spouse during a marriage is deemed as belonging to both spouses equally, regardless of who acquired said asset. If you live in a state that applies community property rules to a divorce, then you can expect that whatever money you contributed to your 401(k) throughout the course of your marriage will be divided 50/50 in the divorce settlement. Money that you contributed to your 401(k) prior to your marriage is not considered a marital asset. As such, that money would remain with you. 

Equitable Distribution States

Equitable distribution states take a slightly different approach to the distribution of marital assets in a divorce. If you live in an equitable distribution state while you are going through a divorce, the court will attempt to divide marital assets as equitably as possible. When determining how to divide your assets fairly, they will consider such factors as how long you were married and the earning potential of each spouse. It is not guaranteed that contributions made to a 401(k) throughout your marriage will be split 50/50.

What Is a QDRO?

A qualified domestic relations order, also referred to as a QDRO, is a court decree that creates or acknowledges the right of an alternate payee (someone other than the plan participant) to receive a portion or all of a participant’s retirement benefits. It will outline the following:

• Who the alternate payee is that has a claim to all or some of the retirement benefits

• The percentage of, or the exact dollar amount that the alternate payee is owed

• The time period or number of payments applicable to the order

• Names and addresses of all parties involved (plan holder and payee)

Who Can Benefit From a QDRO?

The alternate payee in a QDRO can only be the participant’s spouse, ex-spouse, children, or dependents. 

Who Issues a QDRO?

A QDRO is typically issued by a state court, but if the requirements outlined in the QDRO are not in line with the rules of the retirement plan, then a retirement plan administrator has the authority to reject it. 

How is a QDRO Distributed?

Once the terms of the QDRO have been settled, the alternate payee will have a few options in regard to how they will receive their portion of the 401(k). The money can be distributed in one of the following manners:

Are 401(k)s Taxed In a Divorce?

The tax rules that apply to a 401(k) in the event of a divorce are pretty straightforward.  

If the payee chooses to roll the assets directly into their own qualified retirement plan via direct transfer, no taxes would be owed until the payee starts taking distributions from it. Once they begin taking distributions, they would be expected to pay standard federal and state income taxes on any payments received. 

If the payee decides to leave the money in the plan holder’s account until the plan holder retires, again, they will not pay any taxes on the money until they start receiving distributions.

If the payee elects to receive a lump sum cash out, or a cash out in the form of monthly payments, they will have to pay federal and state income taxes on the amount received. 

If money is withdrawn from the account before the divorce is final, the participant owner would be the one to owe taxes on the money, and they would also owe a 10% penalty for early withdrawal if they are under the age of 59.5 years old.

What is “Tracing?”

Tracing, also referred to as asset tracing, or property tracing, is the somewhat complicated process of determining and proving which assets are marital property and which assets are separate property. Essentially, tracing determines who owns which assets and helps ensure that the equitable division of assets only applies to community property. 

As a general rule, anything earned or purchased throughout the course of the marriage, regardless of who earned or purchased it, is considered community property and is owned equally by both spouses. In cases where one or both spouses brought separate funds to the marriage and mixed them with community property, their assets have become commingled. Identifying who is entitled to what may require tracing the original source and/or movement of various assets. 

To thoroughly trace these assets, the following steps should be taken:

• Research the origin of each asset

• Research what each asset was valued at prior to marriage

• Investigate financial statements and tax returns for each spouse

  • Look for hidden or undisclosed property or offshore accounts

• Look into financial statements from prior to the marriage to determine what each 401(k) was worth before marrying

• Search for records of sales or transfers of assets that took place during the marriage

Any separate property that gained value throughout the course of the marriage is still considered to be separate property at the time of divorce. If the ownership of any asset is contested, the burden of proof will lie with the person raising the objection. 

How Can a Divorce Attorney Help?

If you are going through a divorce, you don’t have to face the complicated stuff alone. Working with a qualified divorce attorney will ease the process and give you peace of mind when it comes to determining what will happen to your most valuable assets. For more complex situations, or if you have a large number of assets, it may also behoove you to speak with an experienced financial advisor. Together, these professionals can help ensure that you get to keep what’s yours, and they can provide you with valuable advice about how to take care of your assets moving forward.