Defined Contribution Plans such as 401(k), 403(b), 457 and the federal Thrift Savings Plan are the most common type of retirement account. I will refer to them as 401(k)s in this article. Below are main things to understand about them in a divorce.
Normally an employee contributes to these plans via pre-tax payroll deductions. The maximum amount that can be contributed in 2020 in $19,500 (plus an additional $6,500 if you are 50 or older). Often the company matches the contributions up to a certain dollar amount or percentage.
The plan invests the contributions and the account normally grows over time. The account is adjusted periodically for investment gain or loss. The current value is reported to you in regular statements. With a defined contribution plan such as a 401(k), an employee on termination or retirement always has the option to receive the entire account balance in one lump sum.
A major attraction of retirement plans like 401(k)s is that you defer paying income taxes on the money that accumulates in the plan. When you finally start making withdrawals, they are taxed just like ordinary income.
On the surface, 401(k)s are simple to value. This is because the value at any given time is simply the account balance, much like a bank account.
However, let’s say you need some cash after a divorce. If you plan to withdraw money from a 401(k), the employer will probably withhold 20% of the amount withdrawn towards the taxes that will need to be paid. And depending on your tax bracket, the amount of state and federal tax that will be due could be greater.
Furthermore, if you withdraw money from a 401(k) before you are 59 1/2 years old, you will face a federal tax penalty of 10% of the amount withdrawn. There are a few uncommon exceptions.
So taxes and penalties can eat a major hole in 401(k) monies withdrawn. If you plan to do this, then be aware that the 401(k)’s account value according to the statement is much greater than the amount of money you can actually obtain from it.
That’s why what you normally want to do with a 401(k) is defer withdrawals until you take the money out gradually during your retirement. That way you minimize the taxes due by:
- making relatively small withdrawals each year of retirement;
- being in a lower tax bracket;
- paying the taxes due with less valuable future dollars.
You can often take a loan out against a 401(k). Money obtained in this way is not subject to taxation. But the loan of course needs to be repaid.
In a divorce, it’s important to determine whether there are any loans outstanding against the retirement accounts. If so, it’s essential to specify who will be responsible for paying off each loan. Most plans cannot transfer any portion of a loan balance to the non-employee spouse. Therefore, the loan would have to remain in the name of the account holder. Beware that sometimes account statements make it difficult to determine whether there is an existing loan balance.
If there are no loans, it’s good to say so in your settlement document. It’s also prudent to say that the account holder will not take out any loans (or make other withdrawals) during the divorce unless they have been explicitly agreed upon.
401(k) Legal Value
If your divorce ends up in court, the “legal” value the court assigns to a 401(k) is the amount that appears on a current statement minus any loans outstanding. As we’ve seen above, this could be a lot different from the real financial value. The real value would take into account realities such as taxes, early withdrawal penalties, possibly other fees and the time value of money.
Community vs Separate Property
If all the contributions to the account occurred between the date of marriage and the date of separation, California law considers them to be community property. The same applies to changes in 401(k) account value during this time. Contributions that were made before marriage or after separation are considered to be separate property. So is the account value growth that arose from them.
Sometimes the monies in a 401(k) are a mixture of community and separate property. Determining an accurate valuation for each component requires analyzing all the monthly statements over the life of the account. This is tedious and it may be hard to acquire all the statements. Therefore, couples sometimes take a simpler approach. This could be based primarily on the value of the account at the date of marriage and its value on the date of separation.
In a divorce, a 401(k) can only be divided (or given to the other spouse) by means of a special court order called a QDRO. Each QDRO is an extra cost – typically $1000 or so. Therefore, it’s usually prudent in a divorce to divide no more 401(k)s than necessary.
It sometimes takes several years to become fully vested in a 401(k). Being fully vested means being fully entitled to all the monies your employer has contributed to the account. If you are not yet fully vested, California law considers non-vested retirement benefits to be community property.
Normally in a divorce you want to work out an agreed-upon division of retirement accounts so that they all can be assigned or divided right away. However, it’s possible with a not-fully-vested account that you might want to wait until full vesting has occurred and then do the division.
If you are unfortunately headed for bankruptcy, 401(k)s are protected in that process, while IRAs are fair game for creditors.