When I'm Sixty-four
Divorce and Retirement
How to divide retirement plans may be one of the most important property decisions you make during your divorce. There are many factors to be considered.
1. Is your plan a Defined Benefit or Defined Contribution plan? A defined benefit plan is the standard, old-fashioned plan where if you work so many years, you get so much money when you retire. Federal and state pension plans are primarily defined benefit plans. Defined contribution plans are plans where you and your employer both contribute to the fund. 401(k) funds, and the 403(b) plans offered by nonprofit organizations, are examples of defined contribution plans. IRAs are also a type of defined contribution plan.
2. Did you earn any of the retirement benefits or make any of the contributions before your marriage? In most states, your spouse is entitled to one half of the benefit or one-half of the contributions that accrued during the marriage. In most cases, the division of the plan requires a separate court order called a Qualified Domestic Relations Order (QDRO). Some lawyers specialize in the preparation of these orders. There must be a final divorce judgment (called a divorce decree in some states) before a QDRO can be prepared and filed.
3. Do you need an expert to determine the value of your pension? While it's easy to decide on the value of most defined contribution plans, defined benefit plans can be tricky. This is especially true of many state-sponsored employee pension plans. Many states have revised their plans over the years, so your actual payout at retirement could be affected by when you started working for your agency. Often the real value of the plan is much more than the value given on your annual statement. If your spouse has a defined benefit plan, you should have an actuary determine the pension's value. Actuaries apply specific standard formulas to determine the plan's actual worth.
4. Now that you know what it's worth, how do you divide it? If you and your spouse both have retirement funds, you can avoid the expense of multiple QDROs by offsetting the value of each spouse's funds against the other's.
5. There are some creative ways to divide pensions, and some considerations, depending on your age when you divorce. If you are ages 20-40, you should distribute the pensions equally. Assuming that each spouse will work until age 65, there will be plenty of time to rebuild. If you are ages 40-65, you may want to consider other options.
a. For most plans, the non-participant spouse, (also called the alternate payee) can draw against the participant's fund once the participant reaches the retirement age specified in the plan. The participant doesn't have to retire before the non-participant spouse can draw on the fund. For example, Ted and Alice were married for 17 years. Ted worked for the state as an accountant for 25 years. The minimum retirement age for Ted's fund is 60. An actuary determined the value of Alice's share (half of the value accrued during the marriage), and after the divorce, a QDRO was filed with the court and the pension fund. Ted is five years older than Alice. Alice can begin drawing on Ted's fund as soon as Ted turns 60, even though Ted has decided to work another five years, until age 65. Alice is only drawing on her portion of the fund (half of the amount accrued during the marriage). All of the benefits that will accrue during the next five years will be added to Ted's half of the fund.
b. Most people in the 40-60 age bracket will choose to protect as much of their retirement income as possible. To do so, you may decide to trade off other assets for your retirement. If there are other assets, such as investment funds, or equity in property, you may choose to allocate those to your spouse in exchange for his or her portion of your retirement fund. Another effective way to offset a pension is for the participant spouse to purchase a life insurance policy equal to their interest in the retirement fund and name their spouse as the irrevocable beneficiary. It is essential to notify the insurance company that maintaining the policy is an obligation of the parties' divorce, that the beneficiary is irrevocable and should be notified immediately if the premiums on the policy become delinquent, or any changes are made to the policy. This action safeguards the beneficiary spouse from the other spouse terminating or letting the policy lapse or changing the beneficiary. If the spouse with the retirement fund is a high wage earner, the parties may agree to permanent spousal support as an alternative. Since spousal support is no longer taxed as income, but retirement income is, this can benefit the receiving spouse.
c. DO NOT be tempted to cash out your portion of your spouse's retirement fund. There are substantial reasons why. First, there are terrible tax consequences and penalties that can cost you as much as 40% of the fund's value. Second, even a small fund can have a significant impact on your retirement, especially if you are young. Five thousand dollars in a typical fund could be worth $40,000 in twenty years. That same fund could be worth $500,000 in forty years. At the time of divorce, your portion of your spouse's defined contributions plans can be rolled over into your existing 401(k) or IRA without penalty.
6. These rules do not apply to children's college funds, even if they are state-sponsored 529 style plans that become IRAs if the child doesn't use all of the funds for education. Children's college funds are considered their property. While couples sometimes disagree about who should manage the children's funds, neither spouse has a right to the funds themselves. While it is always a good idea to begin saving early for your children's education, states do not generally require it. See my post on child support for more information on funding children's education.
