Wealth Dividing Retirement Accounts

Wealth Dividing Retirement Accounts

August 15, 2018
BY: Lesnevich, Marzano-Lesnevich, O'Cathain & O'Cathain

Guest blog by BNY Mellon Wealth Management

Dividing Retirement Accounts in Divorce Proceedings

As we see an increasing rate of divorce later in life, known as “gray divorce,” it’s critical to consider the impact of retirement accounts on a couple’s marital estate. Individual retirement accounts (IRAs), pension plans and other forms of retirement accounts can form a major part of a married couple’s net worth, particularly at later ages. For a divorcing couple, retirement accounts may provide an attractive way to fund a spouse’s share of proceeds, especially in cases where the rest of the marital estate is largely illiquid. However, when retirement assets are significant and retirement is close, attorneys and other advisors need to be aware of the pitfalls and opportunities when dividing retirement accounts.

Dividing Retirement Assets Equitably

When clients are divorcing, it is important to accurately value retirement accounts as early as possible, even if those accounts consist entirely of marketable securities. To achieve an equitable division, assets should be evaluated on an after-tax basis.

For example, a spouse in the 39.6% marginal income tax bracket who receives $500,000 of IRA assets may actually only receive $302,000 in current spending dollars. If the other spouse is in a lower bracket, an alternate solution could be to allocate the IRA to the lower-bracket spouse and give the higher-income taxpayer an equivalent amount in cash or other assets. Determining which option is best can become much more complex if one spouse isn’t planning to withdraw from retirement accounts for many years and expects to be in a lower bracket when withdrawals take place. Another confounding factor is that today’s low rates may not persist when retirement comes.

Using Retirement Assets as Collateral

Dividing major, non-retirement marital assets that are illiquid, such as a family business or a family home, can be challenging. In the case of a family business, it’s usually preferable that the spouse who has been active in the business retain it. In exchange, the other spouse may receive a promissory note or shares in the business (either outright or in a trust), with the understanding that the shares will be redeemed within an agreed-upon time period. This arrangement exposes the non-business spouse to some risk, but retirement assets usually cannot be used as collateral without eroding their tax-deferred status.1

However, if retirement assets are in a qualified retirement plan, it’s possible to obtain a qualified domestic relations order (QDRO) for both spouses’ portions of the plan and then pledge the business owner’s portion to the non-business spouse as collateral for the shares or note.2 Should the business-owning spouse default on this obligation, or drive the business into the ground while starting up a new, competitive business in his or her sole name, the non-business spouse has recourse.3 This approach can be complex, and plan administrators should be engaged early on so they have ample time to review the QDRO before it is finalized.

One important note: If the non-business spouse has to enforce his or her right to the business-owner spouse’s QDRO assets, he or she is liable for the embedded tax. Although the business-owner spouse is in default and still technically owns the assets, the non-business spouse is considered the alternate payee for collection purposes. When negotiating the terms of a QDRO, keep this issue in mind and consider grossing up the amount being collateralized to include anticipated income taxes.

Understanding IRA Rollovers in Divorce

Spouses who receive some of the other spouse’s pension assets must decide whether to roll those assets over to his or her own IRA or keep them in the participating spouse’s plan. There are potential upsides to rolling over: greater control over the assets, more transparency, potentially more investment options and further financial separation from the ex-spouse.

However, if the funds are needed before age 59½, it’s often advisable to leave them in the qualified retirement plan under a QDRO. This allows the alternate payee to withdraw any or all of the funds without incurring the 10% early withdrawal penalty, regardless of age.4

If an ex-spouse does choose to roll over, he or she can protect the tax-deferred status of the retirement assets via a trustee-to-trustee transfer.5 Have the trustee of the qualified retirement plan transfer funds directly to the trustee or custodian of the ex-spouse’s IRA. In this case, no tax is due, whereas distributions made directly to the spouse would incur withholding and possibly early withdrawal fees.

Life Insurance Contracts

A life insurance contract owned in a qualified plan cannot be rolled over to an IRA, as life insurance is a prohibited investment. Prohibited investments acquired in an IRA are treated as distributions.6, 7 Their current value is taxed as ordinary income, and if the IRA owner is under 59½, an additional, early withdrawal penalty of 10% would also be applied.7

If the funds designated for an ex-spouse under a QDRO include life insurance and the contract is small, the alternate payee under the QDRO may decide to cash the policy in, or sell it on the secondary market and roll the proceeds of the sale over to the IRA along with the rest of the QDRO assets.

Alternately, the life insurance policy could be left in the ex-spouse’s qualified plan. This will not totally sever links with the ex-spouse’s financial affairs, but may be the wiser choice if the policy is a significant portion of the QDRO assets.

Substantially Equal Periodic Payments

One option for avoiding the 10% early withdrawal penalty for IRA owners under age 59½ is to establish a system of what are known as “substantially equal periodic payments” (SEPPs). Once SEPPs start, they must continue for the longer of five years or until the owner reaches age 59½. If the withdrawals are modified during this period — including accelerated, fully-taxable additional withdrawals —the plan is considered to have made premature distributions and, as a result, taxes and penalties would then be owed on the entire amounts already withdrawn.8

The IRS has granted an exception to these rules in the case of divorce by indicating that modifications to a SEPP resulting from a divorce settlement may not be subject to penalty and the transfer of a portion of the IRA, per the marital settlement agreement, would be non-taxable.9 However, divorcing individuals with SEPPs should consider obtaining their own private letter ruling to confirm their potential arrangements.

The Pitfalls of Failing to Update Beneficiary Designations

Divorced individuals often need to take proactive steps to ensure the assets in their retirement accounts actually end up in the hands of their intended beneficiaries.

If an ex-spouse remains the designated beneficiary on file with a pension plan administrator, or IRA custodian or trustee, the result upon the account-owner’s death will vary depending on the type of retirement account, state law, and the language in the marital settlement agreement or court order.

For Employee Retirement Income Security Act (ERISA) accounts, the name on the beneficiary designation filed with the plan administrator determines who receives the account balance and/or death benefit. This stems from the view that ERISA should provide a straightforward way for employers to “establish a uniform administrative scheme, [with] a set of standard procedures to guide processing of claims and disbursement of benefits… [and so] forecloses any justification for enquiries into expressions of intent, in favor of the virtues of adhering to an uncomplicated rule.”10, 11, 12 In contrast, IRAs (which are not ERISA accounts) are governed by state law. Some states treat an ex-spouse IRA beneficiary as having predeceased the account owner, but many do not.

For example, Florida enacted statute 732.703, which declares designations of prior spouses void as of the time of divorce, so the IRA passes as if the former spouse had predeceased the IRA owner. However, Florida did not have this provision in 2005. Consequently, in Smith vs. Smith, David Smith’s ex-wife, Sandy, received the proceeds of his IRA despite the fact that she had waived her right to it in the marital settlement agreement.

It is worth noting that courts have shown little patience with those who do not update their beneficiary designations to conform to the provisions of their marital settlement agreements. When ruling on Smith vs. Smith, the Fifth District Court of Appeals noted:

“[The late Mr. Smith] did just what he needed to ensure that the proceeds would go to [Ms. Smith] — he did nothing… He had a year and a half to execute change of beneficiary forms… but for whatever reason, he did not do so. Thus, Ms. Smith is entitled to the proceeds…”13[i]

Unfortunately, as in the case cited here, the surviving spouse typically bears the burden of this oversight, with a future action against the estate of the ex-spouse as possible recourse.

Consider Options Carefully

A divorce presents opportunities for ex-spouses to make a clean break so both are able to go their own ways with their future wealth planning. When all or substantial amounts of a divorcing couple’s assets are contained within retirement accounts, careful guidance is required to ensure the intended outcome of a divorce settlement is fulfilled in light of the many potential tax and other implications of holding assets in, and transferring and withdrawing assets from retirement accounts.

BNY Mellon Wealth Management has a long history of helping families manage their wealth and protect their assets through changing circumstances. We work collaboratively with clients and advisors to provide pre-settlement insights on risk, cash flow, investments and property issues. Our dedicated team of experts includes nationally recognized speakers and published authors on the subject of wealth and divorce. They are focused on providing advice and support for individuals and families, family law attorneys, CPAs and trust and estate attorneys. Contact Kristen Nelson (kristen.nelson@bnymellon.com) or visit our website www.bnymellonwealth.com to learn more about our capabilities and the many ways we serve wealthy families and individuals.

This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2018 The Bank of New York Mellon Corporation. All rights reserved.

1 IRC 401(a)(13)(A); 2 IRC 401(a)(13)(B); 3 This process was confirmed by Private Letter Ruling 9234014.; 4 IRS Publication 590, 2011; 5 IRC 402(e)(1)(B); 6 IRC 408(a)(3); 7 IRS Publication 590, 2011; 8 IRC 72(t)(4); 9 Private Letter Ruling 201030038; 10 Egelhoff v. Egelhoff, 532 U. S. 141, 148; 2001; 11 555 U. S. 285 (2009); 12 97 A.2d 1265(Pa. Super. 2009); 13 919 So.2d 525 (FLA. 5th DCA, 2005)