How 401(k) Assets are Split During a Divorce
Many couples’ biggest asset is their 401(k). For some households, it is the only asset, which is why the method by which a 401(k) is split during a divorce can have a major impact on both spouses’ financial future. It’s important to understand what happens to this type of retirement account during the divorce process. The following steps can help ensure a smooth division of 401(k) assets.
Step #1 – Determine how 401(k) assets will be divided
The rules for how a 401(k) is split vary by state. Most states follow equitable distribution rules, meaning a judge splits the assets as he or she deems fair. This doesn’t always mean a 50/50 split, as the judge often considers other financial accounts and marital assets when deciding on fairness.
A less common approach taken by states is to divide assets is according to community property standards. This means the 401(k) is viewed as joint property that both spouses own, and plan assets are split equally between both spouses.
Be aware, however, that you don’t need a judge to decide how your 401(k) is divided up. If you and your spouse agree on the division, you can record your decision in your martial settlement agreement.
Step #2 – Obtain necessary approvals
Once a method of division has been decided upon, a judge must sign off on a Qualified Domestic Relations Order (QDRO). Once the judge has approved, the QDRO is sent to the 401(k) plan’s sponsor for approval.
Step #3 – Process the QDRO
Once the QDRO has been approved by the judge and plan sponsor, it is sent to the recordkeeper for processing. The recordkeeper will establish two new accounts and split the assets between the accounts as instructed.
Step #4 – Determine what to do with your assets
If you are the employee who has contributed to the account and you are still employed by the company that established the 401(k), you must continue to abide by the plan’s rules. This means you are likely not eligible to withdraw fund unless you meet certain requirements.
If you are the alternate payee, you may have several options:
- IRA rollover – You can choose to initiate a rollover of your account into a personal IRA without incurring taxes or early withdrawal penalties.
- Cash out – If permitted by the terms of the QDRO, you can take a lump-sum distribution without incurring a 10 percent early withdrawal penalty, even if you are younger than 59 ½. However, because 401(k)s are typically funded with pre-tax contributions, you will likely need to pay federal income tax on any amount cashed out.
- Defer payments – If allowed by the plan rules, you can leave your assets invested in the 401(k) until you retire and begin taking distributions. This can make sense if you are younger than 59 ½ and do not need immediate access to the assets. Required minimum distribution rules will apply once you reach age 70 ½.
At Creative Planning, we understand how emotionally draining divorce can be. That is why we focus on providing you with confidence and security by helping you determine your financial need, gain an understanding of your options and make decisions that are in the best interest of you and your family.