Five Retirement Plan Distribution Mistakes to Avoid in Divorce Cases By David Stolz, CPA/PFS, CFP®
A divorce case may appear deceptively simple. Jane wants a settlement from her husband Bill a successful physician. The couple, in their early fifties, has a large home, luxury cars, and a country club membership—and Bill has a large income and a few million dollars in his retirement plan. Other than some nonqualified investment accounts, their assets are illiquid. Jane would like the house, which she adores. The attorney considers rolling over a portion of the qualified retirement account to her IRA as a way to balance out the value of Bill’s practice, which Bill will keep in the settlement. Especially in cases when the majority of the assets are illiquid, such a settlement could appear attractive.
While this kind of deal may help Jane to feel temporarily empowered, it could leave her permanently scarred in terms of her financial life. The upkeep and mortgage on a large house could cripple her cash flow and impact the principal she needs to grow for retirement. After the rollover from Bill’s retirement plan to her IRA, any distribution before she reaches age 59½ would incur a 10 percent early withdrawal penalty. Even with an experienced divorce attorney, the urging of a distraught client wanting to wrap up negotiations and move to the next stage of her life can foster some destructive retirement mistakes that can have a long-lasting impact on her future happiness.
Stolz: Five Retirement Plan Distribution Mistakes
2
Divorce is the clash of three unique interests: legal, tax, and financial planning, according to Supper and Cocozza.1 Legal issues tend to overlay the financial concerns, and even wellinformed divorce attorneys can overlook long-term financial planning implications. Presettlement financial planning can help set a client’s path toward long-term goals.
Financial traps in divorce In reaching divorce settlements, attorneys and financial planners have learned that dividing assets isn’t as simple as adding up the total and dividing by two. The financial objective in a divorce is to determine fair value, which may not be the same as fair “market” value. The client requires a detailed analysis of taxes, cash-flow needs over time, and liquidity, among other factors. When dividing the retirement assets of one spouse to transfer to the other, for example, several potential mistakes can affect the settlement and the potential emotional and financial security of the client. A fair-value financial settlement in a divorce case needs to address three major issues: • “Equal” is relative. An investment account, vacation home, and retirement account of equal “assessed” value don’t have the same net values to a divorce client after using a full financial analysis. • Taxes affect settlement amounts. That $1 million traditional IRA may provide the client a sense of security, but the real value to her is only what is left after taxes have been paid. • Some assets work better with a client’s long-term plan. Assets with continuing cost associated with them, such as weekend homes and expensive cars, may have too great an impact on cash flow.
2
Stolz: Five Retirement Plan Distribution Mistakes
3
Common mistakes in dealing with retirement plan distributions in divorce Financial planners who specialize in divorce cases focus on five major planning issues:
1. Improper rollover of retirement assets Continuing with Jane as an example, she can bypass current taxation by rolling over within 60 days the assets she receives from Bill’s retirement account. The best way to transfer the money is trustee to trustee without Jane taking material receipt of it—this method will avoid the 20 percent income tax withholding required for distributions. Under I.R.C. §402, the former spouse who receives retirement benefits is taxed as if he or she were the plan participant. If the client receives distributions directly from the spouse’s retirement account, an additional amount needs to be withdrawn to cover the bite of any taxes.
2. Delays in the division of retirement assets caused by improper documents During the pre-settlement phase, a financial planner will identify retirement assets as qualified or nonqualified. To move assets out of Bill’s qualified plan to Jane’s IRA, the attorneys would need to use a qualified domestic relations order (QDRO). As defined in I.R.C. §414, the QDRO is a court order that instructs Bill’s plan administrator to transfer a specified portion of Bill’s account assets without taxation. If Bill makes any distributions prior to the fully executed QDRO, then taxation will occur on those distributions.
To transfer qualified retirement assets in a divorce settlement from a 401(k), 403(b), 457, Keogh, profit-sharing, or pension plan, all of which are governed by ERISA, you need the QDRO, which appeared with the Retirement Equity Act of 1984. You can use an ordinary domestic relations
3
Stolz: Five Retirement Plan Distribution Mistakes
4
order (DRO) to divide such nonqualified plans as IRAs, SEPs (simplified employee pensions), unfunded deferred compensation, and most government retirement plans. The attorney drafts the DRO and gets it approved by the plan administrator. It can then become a QDRO so that the benefits may be distributed out of the retirement plan.
Without a properly drafted QDRO, distributions will be delayed until the trustee is presented with proper documentation. Generally, the document must name the plan, identify the participant who will receive part of the account balance or benefit in the plan (called an alternate payee), and indicate the percentage or dollar amount to be transferred. A QDRO cannot change the rules of a retirement plan, so the timing of cash distributions may affect the client’s cash flow.
Many QDROs are technically very complex and most attorneys who work with dissolutions are familiar with the rules. This is not the time to attempt drafting your first QDRO on your own, as those who try often fail. A QDRO should be considered an important divorce settlement document, not simply minor paperwork that can wait until the end of all discussions. Even agreed-upon settlement terms can prove meaningless if a plan administrator doesn’t deem the QDRO valid—and worse, very serious tax and financial implications can result. (Also, a former spouse may not be too responsive to later requests to sign and change documents.)
3. Missing the opportunity to avoid the 10 percent penalty with a cash settlement coming from a retirement account The client has several options if he or she wants to take the cash rather than roll it over into an IRA. Normally a lump-sum payment to a participant under age 59½ is subject to a 10 percent
4
Stolz: Five Retirement Plan Distribution Mistakes early withdrawal penalty. This penalty can be avoided if the person receives a lump-sum
5
payment from the spouse’s qualified retirement plan pursuant to a QDRO, as discussed above. Another way to avoid the 10 percent penalty if the client is under age 59½ is by annuitizing the payments over the client’s lifetime in substantially equal installments. These payments must continue for at least five years or until the payee turns 59½, whichever is the longer time period.
4. Selecting the wrong assets in the settlement A dollar in a retirement account is not equivalent to a dollar in a savings account, nor is either equal to that dollar in a CD, if you consider net value after taxes and possible penalties for early withdrawal. If your client needs cash, consider getting more qualified funds rather than assets from nonqualified plans allocated. Often much of a divorcing couple’s marital estate comprises illiquid assets such as real estate, retirement plans, and IRAs. Sometimes the only way to get cash to one spouse is to take distributions from retirement plans. The recipients will have to pay ordinary income tax on any distributions, but they can avoid the 10 percent early withdrawal penalty on qualified distributions, as discussed above. Since IRAs are not qualified plans, consider 401(k), 403(b), and pension plan assets first. A distribution from a 401(k) would be exempt from the penalty; however, should the client roll the 401(k) distribution into an IRA, this opportunity would immediately be lost (if the client is under age 59½).
5. Not changing the beneficiary designations on retirement accounts Beneficiary designations can outlive divorce proceedings. Jane may divorce Bill and never speak to him for many years, but if he remarries and doesn’t change his beneficiary designations, she could end up with his funds at his death. His second wife would have to argue that he had other
5
Stolz: Five Retirement Plan Distribution Mistakes
6
intentions. As with Bill’s retirement account, Jane’s IRA assets could pass to him if she never bothered to update the beneficiary designation. The rules vary from state to state, but usually after a divorce, the parties would prefer not to inadvertently contribute to their ex-spouse’s comfort in the future. As part of a settlement, Bill could agree to leave her as the beneficiary of his account for a fixed period of years to replace the loss of payments while a child was still in college, for example. Review any beneficiary designations to make sure they are in accordance with the divorce decree or the client’s estate planning wishes—and at times you may even need to monitor the former spouse’s beneficiary designations.
Conclusion For the divorce case of Jane and Bill, the first step in creating a financial strategy would be cash flow and tax planning. The short-term cash-flow planning (one to two years) would determine her cash needs while she lives in the current house—and if she needs to take distributions from the retirement account (via the QDRO to avoid the 10 percent penalty). The three-to-five-year midterm plan would involve two areas: an examination of the viability of Jane’s staying in the current house, given her projected cash flow for that time and the future, and tax planning to better manage income from spousal maintenance and taxable pension payments and to take advantage of home itemized deductions.
While good settlements and solid financial plans for your clients can’t address the emotional sting of divorce, they can provide clients a better foundation for the transition to the next stage of their lives.
6
Stolz: Five Retirement Plan Distribution Mistakes
7
About David Stolz David Stolz has more than twenty years of experience working with high-net-worth individuals in the areas of tax, investment consulting, and financial planning. He earned a Bachelor of Business Administration from Pacific Lutheran University. He holds the designations of certified public accountant (CPA), CERTIFIED FINANCIAL PLANNER™ professional, and Personal Financial Specialist (PFS).
References 1. William J. Supper, CFP®, and Christopher R. Cocozza, CPA, J.D., LL.M., “Will Divorce Sink the Retirement Ship?” Journal of Financial Planning, January 2008. 2. Timothy C. Voit, Retirement Plan Benefits and QDROs in Divorce, CCH Incorporated, 2004. 3. Heather Smith Linton, CPA, CFP®, CVA, CDFP, The Taxing Issues of Divorce, Linton & Associates, PA.
7