Divide, Equalize and Offset, or Cash Out Retirement Accounts?
What should you do with retirement accounts when divorcing in California? You basically have two choices. You can either divide the retirement benefit, or you can determine the value of it (equalize) and offset it against some other marital asset.
There are several types of retirement benefits you or your spouse may have. The IRS provides descriptions of the different plans here. The most common plans are defined benefit plans (think: pensions), defined contribution plans such as profit-sharing plans and 401(k)s, and IRAs. Most mid-size to large employers have two types of plans for their employees: a defined benefit plan and a defined contribution plan.
Your first inquiry is determining whether all or any of the retirement asset is marital or community property. The asset is all or partially marital or community property to the extent employee or employer contributions were made during the marriage. Now, let's take a deeper look at your choices.
Choice 1: Divide the retirement during divorce
When you get a divorce, the only way to get the money paid from one spouse's retirement account to the other spouse is with a qualified domestic relations order (QDRO). Simply stating that the spouse is awarded a community or marital property interest in a retirement asset will not divide the benefit.
A QDRO (pronounced "quad-row") is a court order which is used to divide a retirement plan. The actual order may be a qualified domestic relations order for a private plan or domestic relations order (DRO) for a public plan.
How Hello Divorce helps with QDROs
Hello Divorce works with affiliated legal technology companies that are backed by a team of nationally recognized QDRO and valuation experts. You can use their service to get support, coaching, and guidance from experts, including QDRO attorneys. For more information on QDROs, you can also consult our other resources:
- What is a QDRO?
- Understanding QDROs: Dividing Retirement Plans in Divorce
- How Do I Get My Share of Retirement Savings after Divorce?
Ready to file a QDRO? Hello Divorce can help you secure your retirement post-divorce at a transparent, flat-rate fee. Click here to learn more.
Choice 2: Equalize and offset retirement accounts
Parties may also agree to figure out the value of the retirement account and then offset that account against some other asset. But note that because the values may not be identified, you still may need a QDRO for the offset amount.
What are the most common equalization and offsets?
The most common equalization and offset occurs when the parties have many defined contribution plans (e.g., 401(k)) or IRAs between themselves, and they want to offset them against each other and divide only one defined contribution plan with a QDRO.
Can there be an offset against defined benefit plans or other assets?
Parties may agree to equalize and offset a defined benefit cash balance plan or a traditionally defined benefit plan against other assets. However, this is generally not recommended unless the marriage is very short.
Why? Defined benefit plans function differently than defined contribution plans (e.g., 401(k)) and IRAs. Unlike a defined contribution or IRA where there is a known account balance as of a certain date, there is no value until the participant actually starts the benefit for a defined benefit plan. Because there is no value to a defined benefit plan until retirement, the value must be actuarially calculated based on the present date with values that are estimates. Therefore, when a defined benefit plan is equalized and offset against another asset, there is no way of knowing if the offset award is overstated or understated. As such, there is no way of knowing whether the offset is fair.
What determinations must be made to prepare for equalization and offset?
First, you must determine the value of the retirement benefit and any other property being equalized and offset. If there is any separate property interest in any of the plans, you will need to figure out what is separate property and what is marital or community property.
Warning: Each benefit to be offset is most likely invested differently from the date the equalization and offset is calculated to the date of distribution. If investment choices in each of the benefits differ in any substantive way, one party could end up with less than the other at the date of distribution. If the investment choices are very similar, it should not make a significant difference because both parties will be allocated the same investment earnings or losses at the date of the distribution from each of the respective plans in the offset.
An equalization and offset will not result in a perfect division. The most accurate division of benefits is to divide each plan separately. Regardless, especially with defined contribution plans and IRAs, it may make sense to "horse trade assets" based on estimates depending on the parties' situation.
How does an equalization/offset calculation work?
The calculation generally works as best shown by the following example:
- Determine the date of division: e.g., 12/31/2019. (In almost all cases the date of the division is the applicable marital division date based on your state's law, court order, or the parties' agreement.)
- Determine that the total marital/community interest for each of the benefits as of the date of division as follows: Party 1 Benefits: ABC 401(k) Plan $100,000 DEF 401(k) Plan $200,000 Party 2 Benefits: XYZ 401(k) Plan $50,000 Total marital/community interest: $350,000 Each party's marital/community interest: $175,000
- Party 2 is awarded 100% of Party 2's XYZ 401(k) Plan benefits in the amount of $50,000
- Party 2 is awarded Party 2's remaining total marital/community interest of $125,000 ($175,00 ‚Äì $50,000) from Party 1's DEF 401(k) Plan as of the date of division, plus investment earnings and/or losses thereon.
- Party 1 is awarded 100% of Party 1's ABC 401(k) Plan of $100,000 and the remaining balance of the DEF 401(k) Plan after payment to Party 2 of Party 2's share via a QDRO.
Are there any tax advantages in dividing defined contribution plans separately versus doing an equalization/offset?
With a QDRO for a defined contribution plan, the alternate payee (nonparticipant spouse) has the option to move funds to an IRA or other qualified plan or take the funds as cash. However, if the alternate payee wishes to receive those funds as cash and not roll them into an IRA or other qualified plan, then the alternate payee's funds will be subjected to taxes but no tax penalty for early withdrawal if younger than 59.5. See Internal Revenue Code Section 72(t)(2)(C).
So, if the parties each want defined contribution funds as cash directly from the other's plan and are willing to pay taxes on those funds, then it is better to do a QDRO on each qualified defined contribution plan and not do an equalization and offset.
If I am the participant, should I just cash out my retirement plan, if possible?
Cashing out is usually not advisable, except under rare circumstances. The spouse who withdraws will have to pay ordinary income taxes plus an early distribution penalty. Sometimes, one spouse can take a loan from their plan(s) to purchase the other's interest in it.
There is no one-size-fits-all approach to dividing retirement accounts. Definitely seek the advice of a trusted QDRO expert if you have questions on this topic. If you are not sure what to do, it is always best just to get a QDRO done for each retirement benefit for a fair division.
Unsure about how to divide your retirement plan? Seeking guidance of a QDRO expert?