What you think you would do with a retirement account that might be awarded to you in a divorce is an important consideration when assessing its value. This is because there may be taxes, penalties and fees associated with withdrawals from a retirement account.
Retirement accounts are best left to grow until retirement without withdrawing cash from them in the meantime. If you foresee a need for cash in the short-term, normally it’s best to try to find a source for it other than a retirement account. Possible sources could be a bank account, a property sale or taking out a loan.
A dollar in a retirement account is not the same as a dollar in your bank account. You don’t have to pay tax on the dollar in your bank account so it really is worth a dollar. When monies are withdrawn from most retirement accounts, the tax authorities consider the amounts withdrawn to be taxable income. The main exception is withdrawals from Roth IRAs.
This becomes important in a divorce when stacking up retirement account assets against other financial assets. For example, which would you rather receive in a divorce: a 401k with $100,000 in it or a bank savings account with $100,000 in it? If you need to spend the money in the near future, you would be better off going for the savings account because no tax needs to be paid on withdrawals. If however, you don’t need cash out now and you would keep the $100,000 in the 401k invested for the long term, the $100,000 in the tax-sheltered 401k is likely to grow significantly faster than the $100,000 in the savings account.
Penalties
If you withdraw money before age 59½ from a retirement account such as a 401k, 403b or a traditional IRA, you will probably have to pay a 10% federal tax penalty on top of the income tax that you will have to pay on the withdrawal. There are a few ways to avoid the penalty but they don’t often apply.
It’s often possible to borrow from these types of accounts without any tax consequences or penalties, as long as you pay back the loan.
Legal Value
The value of a retirement account as recognized by the court may be different from what it’s worth outside the courtroom. Normally, the value of a retirement account as determined by the court—its “legal value”—is the following:
- For 401ks, 403bs, personal annuities, and IRAs: the amount that appears on your statement as the current value of the account, less any loans outstanding.
- For pensions: what the plan administrator or an actuary tells you it’s worth.
The legal value does not account for possibly important financial realities: taxes, early withdrawal penalties, early termination fees, and other assessments. This is yet another reason why it’s better to stay out of court and work out your own settlement, perhaps with the assistance of a divorce mediator and/or a Certified Divorce Financial Analyst (CDFA).
