Understanding how to divide retirement accounts
Retirement Accounts come in all shapes and sizes such as an IRA, Keogh, 401(k), 403(b), 457, 409A, Sinplified employee pension, Profit sharing plans, Employee stock ownership plans and others. The IRS provides a detailed list of the types of retirement plans and here is the link.
- Retirement Accounts explained
- The basics – dividing retirement accounts
- The details – dividing retirement accounts
Retirement Accounts explained:
For Michigan divorce purposes, the various retirement accounts can be classified into two types, a defined contribution plans and defined benefit plans.
- Defined contribution plans are retirement accounts where money is deposited by an employee or employer. The money can be deposited into a brokerage account, such as a 401(k) or IRA.
- Defined benefit plans are retirement accounts where the benefit (typically a monthly payment) is defined. Most pension plans are defined benefit plans and pay a defined benefit.
Michigan divorce property law provides for a division of property acquired during the marriage. Retirement accounts are property and if the account increased in value during the marriage, the marital portion is subject to division.
Determining the marital portion can be simple in some cases. For example, for a simple 401(k) or IRA the marital portion of retirement accounts can be determined by subtracting the current value from the value as of the date of marriage. Pension plans, require a more detailed calculation.
Some retirement accounts are called “qualified plans” or tax deferred plans. Qualified plans include a 401(k), 403(b), and pension plans. In order to divide the retirement account, courts require a Qualified Domestic Relations Order (QDRO) which is a special order governed by Federal law.
Retirement accounts that are not tax deferred (“non-qualified”) retirement accounts. Non-qualified retirement accounts include an IRA and do not require a Qualified Order to divide the marital portion. These retirement accounts can be cashed in or rolled over in another account.
As a general rule an early withdraw from retirement accounts results in a 10% penalty if you are under the age of 59 ½. You can avoid a 10% penalty for certain withdraws incident to divorce.
a. Pension plans: Pension plans are also known as a defined benefit plan. Unlike a 401(k) or an IRA where your money grows in a bank or brokerage account a defined benefit plan guarantees a certain monthly benefit. In a defined benefit plan the employer contributes to a plan and pays out a defined benefit upon retirement.
How to divide a defined benefit plan or pension plan:
It is quite common for a spouse to be entitled to 50% of the benefit earned during the marriage. There are three methods for calculating the benefit and they are not equal.
- The first method is theprospective coverture method. This method generally produces the largest marital pension benefit. The Prospective Coverture monthly benefit is calculated as follows: Alternate payee’s awarded % (e.g. 50%) multiplied by the accrued benefit at the date of first commencement multiplied by credited service earned during the marriage divided by Credited Service at the date the benefits first commence.
- The second method is thetracking method. This method produces an intermediate marital pension benefit. The tracking method is calculated as follows: Alternate payee’s awarded % (e.g. 50%) multiplied by the accrued benefit at division date subtracted by the pre-marital accrued benefit.
- The third method is the coverture method. This method generally produces the smallest marital pension benefit and is the most commonly used method for determining the marital portion. The coverture method monthly benefit is calculated as follows: Alternate payee’s awarded % (typically 50%) multiplied by the credited service earned during the marriage divided by credited service at the division date.
b. Individual Retirement Accounts (IRA): IRAs allow you to make tax-deferred investments to provide financial security when you retire. There are two types of IRAs a traditional IRA and a Roth IRA. Distributions under a Traditional IRA are taxable and subject to a 10% penalty if you are under the age of 59 ½. Distributions under a Roth IRA are generally not taxable but subject to a 10% penalty if you are under the age of 59 ½.
How to divide a defined an Individual Retirement Account
Individual Retirement Arrangements are typically divided by rolling over the marital portion to a new account. The marital portion is typically ½ of the contributions and earnings from the date of the marriage to the date of the divorce. To help your lawyer calculate the marital portion we obtain a balance of the account closest to the date of marriage and a balance closest to the date of divorce.
c. 401(k), 403(b) and other defined contribution plans
Defined contribution plans such as a 401(k), 403(b), annuity and other defined contribution plans allow an employee to contribute a portion of their pre-tax wages to individual accounts such as a brokerage account
How to divide a 401(k), 403(b) and other defined contribution plans
The marital portion of a defined contribution plan is typically ½ of the contributions and earnings from the date of the marriage to the date of the divorce. To help your lawyer calculate the marital portion we obtain a balance of the account closest to the date of marriage and a balance closest to the date of divorce. The difference between the two is the marital portion. The marital portion can be rolled over into a new account or cashed out. In either case, since if the defined contribution plan is qualified, a Qualified Domestic Relations Order (QDRO) must be entered to divide.
d. How to avoid a 10% early withdraw penalty
One strategy is to roll over the retirement account, another strategy is to have the non-participant party withdraw cash from a qualified plan and avoid the 10% early withdrawal penalty. This is authorized under Internal Revenue Code section 72(t)(2)(D). After taxes, these funds can be used for a multiple of purposes including to satisfy a debt or saved as cash.
The 10% penalty must be paid by the participant of the plan if he/she makes an early withdraw. This penalty is not accessed to his/her spouse. Therefore, a common strategy to avoid the 10% early withdraw penalty all together is for the participant to transfer his/her share of the retirement to his/her spouse in the divorce and offset the transfer with an award of another asset or to satisfy a joint debt. This brings more money to the table for the parties to work with. A win win.