What You Need to Know About Taxes on Divorce Retirement Settlement

Receiving a retirement settlement as part of your divorce can raise concerns about potential tax implications. You may wonder: Will you face significant tax liabilities? Should you be worried about the IRS? The good news is that with the guidance of an experienced attorney, you can navigate these concerns and avoid unexpected tax burdens following your divorce settlement.

Retirement Settlements in Divorce

401(k)s, IRAs, pensions, and similar retirement accounts are considered financial assets. Like other marital assets in a divorce, these retirement accounts can be subject to equitable division by the court. If any portion of the account is deemed marital property, that portion may be divided between the spouses. Even if the retirement account is classified as non-marital, it may still be divided to fulfill the terms of a financial settlement in the divorce.

An important tool in the transfer of retirement assets is the Qualified Domestic Relations Order (“QDRO”). A QDRO is a domestic relations order “which creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to a participant under a plan” 26 U.S. Code § 414(p)(1)(a), ERISA § 206(d)(3)(B)(i).

A QDRO orders the creation of a retirement account of like kind to the participant’s account for the alternate payee (the person receiving money in the retirement settlement). This ensures that the retirement money is not withdrawn in a taxable distribution but is instead transferred to the other spouse pursuant to the divorce.

Tax Treatment of Retirement Settlements

Tax-Deferred Accounts (401(k), 403(b), etc.)

A tax-deferred account like a 401(k) or 403(b) allows a participant to deposit money into the account “pre-tax,” meaning no taxes are paid upfront on that portion of your income. These retirement accounts allow you to defer paying taxes on that income until you withdraw the money from the account. The rationale is that after you’ve retired, your income from employment or business will be lower and thus you’ll be in a lower tax bracket. In effect, this allows you to pay a lower tax rate on the money withdrawn from the account than you would have paid on it as part of your regular income taxes.

As part of a divorce, transfers of funds from tax-deferred retirement accounts can be made as either (1) a direct cash payment from the account to the ex-spouse or (2) pursuant to a QDRO. The IRS considers direct cash payments from tax-deferred accounts as withdrawals from the account and those transfers will incur significant tax penalties as such. That means you’ll owe taxes on the cash distribution as if it were income, plus a 10% penalty for early withdrawal. So, while you do get the benefit of cash up front with this option, it comes at a hefty price from the IRS.

However, transfers pursuant to a QDRO are not taxable. The QDRO creates a similar tax-deferred account for the ex-spouse receiving the money, preserving the tax-deferred status of the funds. With this option, you will have no tax obligations on that money unless and until you withdraw it. This is the preferable option for the majority of people going through divorce.

Individual Retirement Accounts (IRAs)

There are two types of IRAs, the Traditional IRA and the Roth IRA. Both have limits for how much you can invest (be sure to check with your accounting or tax professional for guidance if you have questions). A Roth IRA allows money invested to grow tax-free and with no tax owed on withdrawals at retirement. A Traditional IRA, however, requires you to pay taxes on the growth and on the withdrawals at retirement. The IRS taxes early withdrawals from either account plus penalty fees.

To avoid taxes when dividing an IRA during a divorce, the transfer must explicitly be referred to as a transfer incident to divorce. Similar to a QDRO, the ex-spouse receiving the money can open their own IRA and have the settlement amount transferred in. Depending on the plan administrator, this might be considered a rollover or a transfer. In any case, this type of transfer incident to divorce is not a taxable event.

However, if your divorce Judgment doesn’t explicitly state that the transfer should be a transfer incident to divorce, both spouses may owe tax and early withdrawal penalties for the entire amount of the transfer. Make sure you consult with an experienced family law attorney who can help you be sure your IRA is transferred appropriately.

Pensions

Pensions are retirement plans offered through either a public or private employer that disburse agreed-upon benefits at retirement, often through monthly payments that last from retirement until the person’s death. The person receiving those benefits at retirement will have to pay income tax on the pension payments received.

Pensions through private employers may only be divided pursuant to a QDRO. The ex-spouse receiving the money will owe no tax on the transfer, but will owe taxes when they withdraw from the account. Pensions through State of Illinois public employers, like public schools or police departments, may only be divided through a Qualified Illinois Domestic Relations Order (QILDRO) (instead of a QDRO). A QILDRO serves the same purpose with the same tax implications, but complies with Illinois state laws governing public employee pensions.

When Taxes Are Due

The general rule for retirement funds is that taxes are due when the funds are withdrawn. The type and amount of tax paid depends on the type of retirement account, time of distribution or withdrawal, and the amount of the distribution or withdrawal. The person withdrawing the money from the account at that time will be responsible for paying the taxes.

Conclusion

Navigating the tax implications of retirement settlements in divorce can be complex, but with proper planning and the help of a knowledgeable, experienced attorney, you can minimize potential tax burdens. Whether dealing with 401(k)s, IRAs, pensions, or other retirement assets, understanding how they are divided and taxed is essential for ensuring a fair financial outcome. By addressing these tax considerations early in the process, you can avoid unexpected IRS liabilities and move forward with greater peace of mind. Be sure to consult with an experienced legal professional to guide you through this important aspect of your divorce settlement, and to consult with a tax professional to ensure your tax obligations are fulfilled.