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Not All Retirement Assets Are Created Equal

It is important for professionals and their clients to understand the features and characteristics of the assets they have before them when they are trying to decide how to divide them in a divorce.

The terms defined benefit, defined contribution, 401(K), pension, IRA, qualified, non-qualified and annuities can be very confusing and need to be understood before any decisions are made while negotiating equitable distribution. The wrong decision cannot only be costly, but might result in possible penalties and taxes.

Let’s start from the top and drill down.

Retirement accounts are always qualified. The IRS has created a code that governs how the money is treated on the way in and what happens to it when it comes out, specifically how income taxes are paid. Most qualified accounts are funded with money that is withheld from your paycheck or has enabled you to receive a tax deduction if paid with post-tax dollars. Next, there is a difference between defined contribution and defined benefit type plans. By definition, defined contribution plans tell you how much you can put into the account. Conversely, defined benefit plans tell you how much you will receive once you are retired. A 401(k) and an IRA are some examples of defined contribution plans. If you have participated in one of these types of plans, you will get a periodic statement, monthly or quarterly, that shows you a lump sum value as of a specific date. You may have to request a statement if you have elected to go paperless. A pension is an example of a defined benefit plan. Typically, teachers, police officers, firefighters and other government employees are the people that have pension plans. A statement will be generated, usually once a year, showing an amount of money that you will receive as an annual income for your lifetime upon retirement. There are not funds specifically set aside in your name until you retire.

Non-retirement accounts are non-qualified. These include, but are not limited to, such things as mutual funds, savings and brokerage accounts that have money YOU have put aside that is not governed by a specific IRS code. This money is invested by an individual after income tax has been paid on it. It is not part of a company retirement plan.

The importance of knowing what you have before deciding how to divide it cannot be stressed enough. A defined contribution plan with a cash value is easy to calculate. $100,000 split between two people 50/50 means $50,000 to each. The nuance here is how much of the money was accumulated prior to versus during the marriage. A defined benefit plan is much more complicated to divide because there is no cash value held in an account for the individual. Rather, a formula needs to be used in order to determine the present-day value of the future benefit. Then, depending on the duration of the marriage, a factor needs to be calculated to determine what percentage of the total is pre-marital versus marital (i.e., Earned as a result of efforts made during the marriage). Finally, a third formula is employed to arrive at the amount that will be awarded to each spouse for the purposes of equitable distribution.

Lastly, annuities are investment vehicles that provide both a lump sum value and a future income value. They either have a fixed rate of interest or the ability to invest in a variety of stock and bond funds. These products can be found in both qualified and non-qualified accounts. The owner of an annuity will designate beneficiaries to receive a death benefit once they have passed away. A statement will be generated periodically, showing a lump sum cash value as of a specific date. Additionally, annuities can provide lifetime income to the owner/annuitant of the contract. Annuities that have lifetime income features need to be handled differently because there is a future income benefit associated with them, not just the cash value. Their equitable distribution calculations should be similar to how a defined benefit/pension is handled during negotiation.

If you are not certain about the retirement assets you hold, it would be in your best interest to consult with a financial advisor who understands the nuances of these investments. The ramifications of not doing so can be costly in assessing the proper value of the assets or the tax implications of the distributions in comparison to other assets that might be divided.

Written by Donna LaScala, RFC, CDFA

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