Retirement - How to Value and How to Divide

Retirement assets are savings or other benefits that have some sort of favorable tax implications when used in your later, retirement years. Retirement is one of the most complicated financial assets to understand whether you are going through a divorce or not. It is important to first understand the particular types of retirement accounts or benefits and then we will walk through how they are handled in divorce.

To start, as a preliminary matter, retirement accounts can only be held in one person’s name. A retirement account by definition is an individual account.  Your spouse, or anyone else for that matter, may be listed as a beneficiary on a retirement account, but retirement cannot be jointly held.  If you see an account that is held jointly, with two people named, it is most likely not a retirement account.

Types of Retirement Accounts

It is important to understand the two main types of retirement accounts: qualified and non-qualified plans. Understanding what type of retirement account you have will then dictate how it may be divided in a divorce.  

QUALIFIED RETIREMENT PLANS

Qualified Retirement Accounts, also known as tax-qualified retirement plans or sometimes pre-tax retirement savings, are specific types of retirement accounts or arrangements that meet requirements established by the Internal Revenue Service (IRS) in the United States. These requirements are designed to provide tax advantages to both employers and employees while encouraging individuals to save for their retirement. Typically qualified retirement accounts allow for you to save for retirement without paying taxes on the money going into the savings. So your employer can provide you savings for retirement and/or you can save out of your income, lowering the amount of taxes you pay on your income at the time of saving.

Qualified plans are usually sponsored by employers, often with the company name in the title, and they all come with several key characteristics:

1. Tax Benefits: One of the primary advantages of qualified retirement plans is the favorable tax treatment. Contributions made to these plans are often tax-deductible for the employer, and the funds grow tax-deferred until retirement for the employee. The earnings on these investments grow without taxes, meaning that you do not pay taxes on the gains until you withdraw the funds in retirement.  When individuals withdraw funds during retirement, the funds are subject to income tax, but typically at a lower rate. If you withdraw funds prior to retirement or before a certain age (like 59½), you would have to pay taxes and usually a penalty.
2. ERISA Compliance: Qualified plans are subject to the Employee Retirement Income Security Act (or ERISA). This means they must adhere to certain standards and rules designed to protect the rights and interests of plan participants.  These protections are often why the plans seem so complicated – they are heavily regulated which, while intended to protect you, makes them a lot more complicated.
3. Sometimes Employee Participation: Employers generally offer qualified plans to their employees, and in many cases, employees are eligible to participate after meeting specific criteria, such as a certain period of service or reaching a specific age.  This is where “vesting” may come into play.  You may have retirement that is not yet vested or partially vested.  You may also have retirement funds that are funded by your employer alone or partially funded by your employer and you as the employee. Sometimes qualified plans have matching provisions, where they will match your contributions up to a certain percentage. So if you contribute they will match your contributions up to a point.  This can be a really good benefit if you can afford to save for retirement.
4. Contribution Limits: Qualified plans often have limits on how much an can be contributed each year. These limits are set by the IRS and can vary depending on the type of plan and the employer’s choices.

Let’s walk through the most common types of qualified retirement plans include:

• 401(k) Plans: These are employer-sponsored retirement plans that allow employees to contribute a portion of their salary to the plan. These contributions are deducted directly from the employee's paycheck. The advantage of making pre-tax contributions is that it reduces the employee's taxable income for the year, potentially lowering their income tax liability.
  • Many employers who offer 401(k) plans also provide a matching contribution. This means that the employer will match a certain percentage of the employee's contributions, up to a specified limit. For example, an employer might offer a 50% match on the first 6% of an employee's salary contributed to the 401(k).
  • 401(k) plans are designed for retirement savings, so there are penalties for withdrawing funds before a certain age (typically 59½) unless there is a qualifying event, such as disability or financial hardship. Early withdrawals are subject to income tax and a 10% early withdrawal penalty.
  • When an employee changes jobs or retires, they have the option to roll over their 401(k) account into an Individual Retirement Account (IRA) or a new employer's 401(k) plan. This rollover allows for continued tax-advantaged growth.
  • The IRS sets annual contribution limits for 401(k) plans. These limits may change from year to year.
  • Employees are always fully vested in their own contributions and earnings. However, employer contributions may be subject to a vesting schedule, meaning the employee must work for a certain number of years before those employer contributions become fully owned by the employee.
  • Employees usually have control over the investment choices for their 401(k) retirement funds.
• 403(b) Plans: Also called “tax sheltered annuities” or TSAs are similar to 401(k) plans but are typically offered to employees of tax-exempt organizations, like public school teachers, nurses, non-profit organizations, and certain ministers.  Government employees may have access to similar tax-exempt plans called 457(b) Plans.
  • While these accounts share similarities with 401(k) plans, they are subject to specific regulations that cater to the needs of employees in the non-profit and public sectors. Matching, vesting, and investment options for these accounts may vary but the overall tax-impacts and benefits are usually similar to 401(k) plans.
• Pension Plans: Also called “Defined Benefit Plans.”  These retirement plans offered by some employers, promise a specific retirement benefit, often a fixed monthly or annual payment in retirement. Here are the key characteristics of a pension plan:
  • Guaranteed Retirement Income: In a pension plan, employees are promised a specific monthly or annual retirement income, based on factors like salary and years of service. This guaranteed income provides financial security in retirement.
  • Employer-Funded: Defined benefit plans are primarily funded by the employer. Employers make contributions to the plan on behalf of their employees. Employees usually don't make contributions to these plans, although some employers may allow voluntary contributions.
  • Calculation Formula: The formula used to determine retirement benefits in a defined benefit plan considers various factors, including years of service, average salary over a period of time, or high salary years. The longer an employee works for the company and the higher their salary, the larger their pension benefit usually is.
  • Age and Service Requirements: To qualify for full pension benefits, employees often need to meet certain age and service requirements, such as reaching a specific age and completing a minimum number of years of service with the employer.
  • Vesting: Defined benefit plans typically have vesting schedules that determine when employees become entitled to the benefits. Vesting may require several years of service before an employee has full ownership of their pension benefit.
  • Payout Options: When employees reach the plan's retirement age, they have various options for how they receive their pension benefits. They can choose between a lump sum payment, annuitization (receiving periodic payments), or a combination of both.
  • Spousal Benefits: Many defined benefit plans offer spousal benefits, ensuring that the surviving spouse continues to receive a portion of the pension benefit in case the plan participant passes away.  It is important to understand this “survivorship” element of pensions because it may come up in divorce.Plan Funding: Employers are responsible for ensuring that the pension plan is adequately funded to meet future benefit obligations. This involves making regular contributions and managing investments to cover future pension payments.
  • Regulation: Pension plans are subject to government regulations, including funding requirements and reporting obligations. The Employee Retirement Income Security Act (ERISA) in the United States sets guidelines for the administration and protection of pension plan assets.
  • Pension plans were more common in the past, especially among government agencies and large corporations. However, many employers have transitioned to defined contribution plans, such as 401(k) plans, which place more responsibility on employees to fund their own retirements. Defined benefit plans are often considered more traditional and less prevalent in the current employment landscape. But we see them a lot in divorce and, if someone has been working for a company with a pension benefit for a long time, there could be a fairly substantial pension benefit that needs to be considered in a divorce.
• Profit-Sharing Plan: These allow employers to make contributions to the retirement accounts of their employees, often based on the company's profits. The participant in a profit sharing plan often have some flexibility or freedom to make investment choices in their plans.

Defined Contribution Plans v. Defined Benefit Plans

There is another distinction within qualified retirement accounts that you should understand. As you can tell, all retirement accounts are defined plans with rules and regulations attached. Some of the rules address the contributions made and others address the benefit paid in retirement.  This is where the terms Defined Contribution Plans or Defined Benefit Plans come from.  

• Defined Contribution Plans, like 401(k)s, have rules about the contributions made now to be used later in retirement. The benefit in the future is determined by the contributions made and the investment returns.
• Defined Benefit Plans, like pensions, have rules about the benefit paid to the employee in retirement. The defined payment, once granted by the employer, is typically guaranteed.

NON-QUALIFIED RETIREMENT PLANS

At their very simplest, non-qualified plans are any retirement account that isn’t a qualified plan.

While all qualified plans are administered through employers, that isn’t necessarily the same for non-qualified plans.

• Individual Retirement Accounts, also known as IRAs, are the most common type of non-qualified plans. IRAs are not employer-sponsored plans like 401(k)s or pension plans; instead, they are established by individuals to save for retirement. There are different types of IRAs, each with its own features and tax advantages. Primary types of IRAs are:
  • Traditional IRA where contributions are typically tax deductible when made, which can reduce the contributor's taxable income for the year in which the contributions are made. The earnings then grow tax-deferred, meaning that you don't pay taxes on the gains until you withdraw the funds in retirement.  Like a 401k, distributions from a traditional IRA are typically subject to income tax at that time. If you withdraw funds before the age of 59½, you may also incur a 10% early withdrawal penalty. If you are over a certain age, like 72 ½., you ae required to take minimum distributions or RMDs every year.
  • The other type of IRA is a Roth IRA. The main difference between these two is that contributions to a Roth IRA are not tax-deductible. You make contributions with after-tax dollars but then the withdrawals in retirement, including earnings, are tax-free. This means that you don't pay taxes on the withdrawals you make in retirement. Roth IRAs offer other flexibility. For example, you can withdraw your contributions (but not earnings) at any time without penalty. And there is no requirement for RMDs during the account holder's lifetime.
  • Additionally, there are specialized IRAs, such as a Simplified Employee Pension (SEP) IRA for self-employed individuals and Savings Incentive Match Plan for Employees (SIMPLE) IRA which is a way for small businesses to provide employees benefits. An Inherited IRA or Beneficiary IRA are IRAs that have been inherited and have different distribution and tax rules.

Finally, there are other Non-Qualified Retirement Plans that are offered by employers as incentives for employees. These are unusual and often don’t have standard regulations or rules. Some examples of these plans are:

• Deferred Compensation Plans
• Supplemental Executive Retirement Plans (SERPs)
• Executive Bonus Plans
• Top Hat Plans
• Stock Appreciation Rights (SARs) Plans
• Phantom Stock Plans
• Long-Term Incentive Plans (LTIPs)
• Section 457 Plans
• Golden Handcuff Plans
• Salary Continuation Plans

Steps and Example of Retirement Division

When working through division of retirement in divorce, the first step as in any category of property division, is to identify all the retirement accounts and who is the named participant (remember retirement accounts can only be in one person’s name).

For each account or plan, you want to have the complete title, type of account it is, a recent balance or benefit amount, and the date of that valuation.  It’s also important to determine whether the account is a pre-tax account, which will be taxed at distribution, or a post-tax retirement account where contributions are made from post-tax dollars. You want to make sure you are comparing similar categories of retirement assets then thinking through divisions. Note that the value of any defined contribution plan can be found on a statement or by requesting a balance from the Plan directly.  A defined benefit plan, like a pension, can be much more difficult to value.  See the section below on defined benefit division options.

Example of Dividing 401ks and IRAs

Start by laying out the retirement accounts in a balance sheet to analyze them more clearly.  Here is an example with each spouse having various pre-tax and post-tax retirement accounts:

Before looking at options to divide these accounts, you should separate out the pre-tax and post-tax accounts as shown below:

The next step is to move the values into each named spouse’s column to show the different values each has in their own name.

You can see the different values in retirement between each spouse and keep in mind that this includes both pre-tax and post- tax retirement.  Because the Roth IRA’s in the option above will not be taxed upon withdrawal in retirement, Spouse 2’s retirement accounts have additional value than what is apparent in the numbers above.

If all of the retirement accounts are marital/joint and the parties agree to an equal division, it often will look like this:

By Spouse 1 transferring $110,000 in 401k to Spouse 2 and then Spouse 2 transferring $37,500 in Roth IRA to Spouse 1, both spouses end up with one half of the retirement assets and an equal sharing of pre-tax and post-tax assets.

Now what if there are portions of retirement that are non-marital or separate property?  This often occurs where a party had retirement at the time of marriage (pre-marital) retirement or if a party has an inherited retirement account that wasn’t earned or saved during the marriage.  Similarly, someone might inherit money or other assets and transfer it into a retirement account that would be non-marital/separate. When there is non-marital/separate retirement, it is often individually awarded to the named spouse and not included in the overall shared retirement.  

Sometimes an asset is considered a hybrid account, if there are marital and non-marital portions.  This happens commonly if a retirement account is started and funded prior to marriage and then continues to be funded after marriage.  This hybrid asset will need to be categorized as both marital and non-marital with values assigned to each.  A trained attorney and/or financial expert could help identify the value of non-marital/separate property in a retirement account.  Obtaining a statement from the time of marriage or requesting something from the Plan administrator showing the balance at the time of marriage can help with this analysis.  The main consideration once you know the balance at the time of marriage is whether or not growth on the pre-marital amount remains non-marital/separate – different jurisdictions may account for this differently.  It is common to attribute growth on pre-marital retirement to the pre-marital amount.  

Here is an example if you assume a 7% growth rate on the account since the time of marriage:

If you can obtain the average growth rate on the account during the marriage, you can calculate the growth on that separate amount.  The plan administrator may be able to provide the annualized growth on the account or you could agree to base it on norms, like published growth rates of the S&P or NYSE. Once you determine the total non-marital/separate value, the remaining balance in the account is then marital/joint.  This type of high-level analysis can be used in negotiations but a Court may require a more detailed analysis by an expert who can look at the actual growth on the accounts.

Non-marital retirement values are typically separated out in an equal division of retirement as follows:

Pensions and defined benefit plans where a participant receives fixed payments in retirement may be difficult to value in a divorce. Pension statements or updates for plan participants often only provide a potential monthly payment amount expected at certain ages in retirement. There isn’t typically a present value provided to the participant.  If there is a “lump sum” number provided by a plan, it may not be accurate for divorce purposes.  Such a number in a statement often only accounts for contributions provided by the employee or other limited calculations or may be the amount the pension would offer to cash out the plan, without a full analysis of the true present value. One option in a divorce is to divide the monthly benefit between the parties and, if this is the decision, no valuation is needed.  If, alternatively, the pension beneficiary wants to keep the pension and buy the other out of it, then you need to obtain a present value.  This value should replicate the amount of funds needed now to provide the anticipated monthly or annual benefit guaranteed in the pension.  There are a number of complicating factors in this valuation, such as assumptions on growth and cost of living increases as well as how long the beneficiary may live.  There are some online calculators to estimate a pension value but it is best to use a certified appraiser if an accurate estimate is needed.  

Let’s look at an example:

If both spouses agree on using the age 66 value, an appraised value may come in around $260,000 based on an actuarial analysis. You should have an expert or attorney or financial advisor run this type of calculation for you if needed. This is the amount that would be used in a property division.  

Here are the two options for handling a division of a defined benefit like this:

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If there are non-marital/separate portions to the pension, for example from years worked prior to marriage, an actuarial analysis can account for that difference and calculate out the separate portion.  Then the non-marital/separate portion of the pension can be accounted for and stay with the plan participant while the marital/joint portion is accounted for in the shared division.

Logistics when Dividing Retirement

Finally, there are some logistics to keep in mind when you are dividing retirement accounts.  

Tax Implications of Dividing Retirement

Most importantly, you should know that the transfer of retirement pursuant to divorce should be a non-taxable event.  You should not cash out retirement, incur taxes and possibly penalties for being too young, and then shift funds over.  Instead, the division of retirement in a divorce should be a non-taxable event. Most retirement accounts can be divided and transferred from one spouse to another with a signed and final divorce decree.  For non-qualified plans, like IRAs or SEPs, you will likely need to provide the plan participant with a copy of the divorce decree and they can implement the division.  For qualified plans, like 401k or 403b, you will need to obtain a separate court order called a Qualified Domestic Relations Order (QDRO).  See the QDRO module on post-divorce division of retirement.

Cashing Out Retirement During Divorce

There is a one-time opportunity to cash out qualified retirement funds without the 10% early withdrawal penalty that you receive in a divorce pursuant to a QDRO.  While you will still be taxed on the distribution, you can avoid the pre-retirement penalty.  This may be an option to creatively use retirement funds for cash needs.  See the QDRO module on post-divorce division of retirement to learn more.

Timing and Valuation

Because retirement division happens after a divorce is complete and it may take time to implement the change, you need to account for changes in the retirement balance based on changes in the market.  As you know, retirement balances often fluctuate on a daily basis based on the underlying investments.  If one spouse is awarded $150,000 from a retirement account based on balances before the divorce, when you implement that division months later, the balances will undoubtedly be different. To account for that, most retirement divisions are adjusted for gains and losses from the valuation date to the date of division. For example, if Spouse 1 is awarded $150,000 based on a 12/31/2023 valuation, to account for changes in value, you could award “$150,000 as of 12/31/2023 adjusted for gains and losses through the date of division.”  When the plan is implementing the division, they will look at how the $150,000 as of 12/31/2023 has increased or decreased based on the market. If the market is up, Spouse 1 will receive more than $150,000 and if the market is down, Spouse 1 will receive less.  This is meant to replicate what the value would have been if Spouse 1 had actually received the $150,000 on 12/31/2023.

Emotional Considerations

When dividing retirement accounts in divorce, emotional considerations can play a significant role for both spouses. Retirement accounts often represent years of hard work, dedication, and financial planning. For many individuals, these accounts hold a strong emotional attachment and may symbolize their identity and sense of security for the future.  Dividing retirement accounts can evoke feelings of loss, uncertainty, and anxiety about one's financial future and retirement plans.

Divorce can also trigger emotions related to fairness and justice, particularly regarding the division of assets accumulated during the marriage, including retirement accounts. Spouses may feel a sense of entitlement to a fair share of the retirement accounts, especially if they contributed directly or indirectly to the accumulation of funds during the marriage. Dividing retirement accounts can heighten fears of financial instability and insecurity, especially for individuals who relied on these accounts as a primary source of retirement income.

Concerns about the adequacy of future financial resources and the ability to maintain one's standard of living post-divorce may exacerbate feelings of anxiety and stress. Dividing retirement accounts can have profound implications for your lifestyle choices and future plans, including retirement goals, travel aspirations, and lifestyle preferences.  Adjusting to the financial realities of a divided retirement account may require reassessing and potentially revising long-term plans and expectations.

Seeking emotional support from friends, family members, or mental health professionals can be instrumental in coping with the emotional stress and challenges associated with dividing retirement accounts in divorce. When dividing retirement accounts in divorce, it's essential to recognize and address the emotional considerations that may arise for both spouses. By acknowledging and validating these emotions, spouses can work together to navigate the process with empathy, understanding, and mutual respect, ultimately facilitating a smoother transition into the next chapter of your lives.