Dividing Retirement Benefits in a Divorce
One of the most often asked questions about equitable distribution of marital assets is how a retirement asset is divided between spouses. The answer depends largely on the type of retirement account being divided and what rules are associated with the retirement account.
All retirement accounts are not alike. The first question that must be asked is what type of retirement account are you dealing with? Generally, retirement plans are one of two types: a defined contribution plan or a defined benefit plan.
A defined contribution plan is a retirement plan in which the employee, or in the case of an IRA, the individual, contributes a set amount. An employer may match contributions up to a certain amount. The most well-known type of a defined contribution plan is a 401(k) plan. The employee typically has a portion of his or her paycheck deducted, which goes into the account. Many times, an employer will match a percentage of the deduction up to a cap. The deductions are pre-tax, meaning that the money comes out of the employee’s gross pay before taxes are withheld. The money is then taxed when the employee retires. The assumption is that the employee will be at a lower tax bracket at the time of retirement. The individual always knows how much is in the account and what the retirement is worth. For example, if after five years of employment the employee has contributed $30,000 and the employer has contributed $10,000, and the account has earned $400 in interest, the account value is $40,400.
A defined contribution plan that is divided in equitable distribution is distributed to each party via a transfer after a judgment of divorce is entered. In other words, if one spouse has $150,000 in a 401(k) account, after the divorce, there will be a transfer to the other spouse into an IRA or similar retirement account. So long as the transfer is into a similar account, the funds will not be taxed.
A defined contribution plan is a plan in which the actual amount will not be determined until retirement. The most common defined contribution plan is a pension. The employee contributes towards the pension during employment, and then when the employee retires, a benefit will be paid based on formula the employer uses, typically taking into account the number of years worked, and the final salary at the time of retirement.
Dividing a defined benefit plan is trickier than a defined contribution plan. The value of the benefit can be divided at the time of the divorce, or at the time the employee begins to receive the payments. To divide the benefit at the time of divorce, the present value of employee’s benefit which was accumulated during the marriage has to be determined. This is done by taking the known values, such as length of service and present salary, making assumptions of the employee’s age at which retirement is allowed under the plan, as well as assumptions of economic growth. The valuation is typically done by an actuary or other similar expert. The present value of an employee’s future pension is usually quite large and unless there are other marital assets which are liquid that can be offset, distribution usually has to wait until after the employee retires. This is known as a deferred distribution.
In order to divide a defined benefit plan after divorce, an order oftentimes known as a Qualified Domestic Relations Order will be signed by the court which directs the administrator of the retirement plan to pay a portion to the former spouse when the employee retires. The question that has to be asked is what is the appropriate portion. The only part of the benefit that a former spouse will be entitled to in equitable distribution is that portion that was earned during the time the parties were married. Yet the employee may have been working before the marriage, and may continue to work after the marriage is over. In order to get the right amount, a fraction is often used in which the top of the fraction is the part of the employment which occurred during the marriage, and the bottom of the fraction is the entire length of employment. This fraction is then multiplied by the percentage of the benefit the former spouse is entitled to typically 50%.
Another issue that should be addressed when dividing a defined benefit plan is survivor benefits. Most plans provide that the benefit stops on the death of the employee or participant, but may have an option that the employee may choose a survivor benefit which will allow a beneficiary to continue to receive benefits after the death of the participant. However, if the employee chooses this benefit, the amount of the benefit usually is less. Depending on the circumstances of the case, it is important to consider this issue when dividing a defines benefit plan.
In many divorces, retirement seems far away, and it is easy to pay less attention to issues that are not “front and center.” However, not giving these issues the attention they deserve can have disastrous consequences later on. Equally important is making sure your legal counsel us familiar with these issues.