Retirement Plans

Next to the marital home, retirement funds are usually the next largest asset involved with the divorce settlement.  Many people wonder if they will lose their retirement savings and if they can use the money in their retirement funds for needed cash.

There are two primary types of retirement funds:

• Defined Contribution Plans

• Defined Benefit Plans

Some retirement plans with special tax status are regulated by the Employee Retirement Income Security Act (ERISA).  These plans allow you to deduct contributions to the plan from your income.  The contributions are not taxable until they are withdrawn.  If you withdraw funds before the allowed age, then you are taxed not only at your income tax rate, but are also charged a 10% penalty. However, if the withdrawal is pursuant to your divorce settlement, then you can withdraw funds without the penalty and only have to pay income tax on the withdrawn amount. 

Defined Contribution Plans are ones in which the person has their own account and there is a certain sum of money in an investment account.  The balance of the account builds as money is added to the account and as the investments grow and generate interest or dividends.  These types of plans include 401(k) plans, profit-sharing plans, money purchase plans, tax sheltered annuities, stock bonus plans, thrift plans, employee stock ownership plans (ESOP), and Individual Retirement Accounts (IRA).

Defined Benefit Plans are ones in which the employer promised to pay the employee a particular benefit when the employee reaches retirement age.  Employers make contributions to the plan, and sometimes they can be topped up by the employee.  The benefit you ultimately receive is based on a formula which often takes into account the number of years you have worked for the employer, your average income over the last three or ten years, and other factors.  The benefits you can receive may provide you with a steady income as long as you live, and it may increase with the cost of living (COLA).  You can also often choose to have joint and survivor annuities, which can provide a pension for your spouse after you die.

The marital portion of the retirement plans is, in basic terms, the portion of the plan that was accumulated and earned during the period of the marriage.  What was added to or earned in the funds prior to the marriage is normally considered separate property and typically not subject to division.  For example, if you have a 401(k) that had a $10,000 balance before the marriage, and had a $100,000 at the end of the marriage, the marital portion would be $90,000.  For defined benefit plans, it is more complicated but takes into account the period in which you were in (or expect to be in the plan) and the portion of that time you were married.  So, let’s say the total time you were in the plan is 300 months and the time you were married is 200 months.  Thus, the “marital coverture” fraction, or the percentage of the pension value that is marital, is 66.67%.   A third of the plan value would be considered separate.  When retirement age is relatively soon, then the computation should be based on retirement age and the valuation of the plan at retirement age.

So, what do you need to know?

• What plans do you and your spouse have?  Get a copy of the statement for each plan.  If you have Defined Benefit Plans, you may need to get a valuation of the plan and find out what the retirement options are.

• What are the rules for each of the plans?  Particularly for Defined Benefit Plans, it is good to get a copy of the Summary Plan Description.

• For Defined Contribution Plans, what were the balances at the beginning of the marriage?

Division of your Retirement Funds.

Once you know the value of the plans, you can decide how to divide these assets.

There are four options:

• Immediate Offset.  If you have other marital assets that can be used to balance the value of the retirement fund, you can give the spouse not receiving the pension enough money from the other assets to equal or offset the value of the pensions. Be aware that there are potential differences in value between the retirement assets and other assets since income taxes often have not been paid on the retirement funds.

• Division of the Plans.  You may wish to divide the value of the pensions now.  For defined contribution plans, this is relatively easy but, in the case of ERISA plans, a Qualified Domestic Relations Order is required.  A QDRO is a document that, once approved by the Court, instructs the plan administrator on how to divide the pension.  Division of defined benefit plans into two separate pensions can also be done using a QDRO, but the implications of these can be complex and parties are advised to seek advice. 

• Deferred Distribution.  It is often beneficial to defer division of a Defined Benefit Plan until retirement of one of the parties in order to determine what the actual amount of the pension will be, but also to secure potential large increases in the value of the pension as retirement age nears.  Again, a QDRO is necessary to instruct the plan administrator on how and when to divide the plan.  Also, it is very important to understand the options and rights available under the plan so that you can make informed decisions.

• Reserved Distribution.  Sometimes you may wish for the Court to make a decision later on how to divide the pension as there may be unknown factors, such as deferred compensation, that may affect the marital value of the plan. 

It is important that you have the agreements you make regarding the retirement funds included in your separation agreement in case the QDROs are not drafted and approved by the time your decree is final.  Unfortunately, if your rights have not been protected in the separation agreement, and your pensioned spouse dies after your decree is final but before the QDRO has been approved, your rights to the pension may be lost.

Also, as part of your divorce settlement, don’t withdraw money from your retirement account and give it to you spouse to deposit in their IRA, unless you want to pay the tax and the 10% penalty.  Even if it is pursuant to your divorce settlement, in order to avoid taxation, you must have the plan administrator do the transfer directly from your account to their account.