Divorce-An Unfortunate Reality

Ifile6431234669588 hate divorce. I really do. I was 8 years old when my parents got a divorce and it was an ugly time. I thank God every day for the strength of my marriage; however, I do understand that divorce is a reality for many people. In fact, in America there is a divorce every 13 seconds, that’s 6,646 divorces per day and 46,523 per week. When I began my financial career 20 years ago, I did not want to just be a financial broker like so many are in my industry. I wanted to be a resource where folks could come and receive unbiased, holistic, financial advice to help folks in any situation. This past week, I helped some people with a sensitive issue, divorce.
Lenny and June (names have been changed for this article) were referred into me last week. An attorney referred them to me in the hopes that I could offer some more guidance than their current advisor can give them. They are getting a divorce and were seeking some advice on how to avoid financial mistakes with their retirement accounts while dividing their assets. Lenny is 50 and June is 48. They have been married for about 15 years. Lenny is self employed and June is a stay-at-home mom. They own their home outright, and Lenny has about $750K in a traditional IRA, and approximately $150K in a 401K.
Lenny and June are very wise to seek advice. A wrong move can cause a tax time-bomb to explode. When they divorce, their financial assets, including their retirement accounts, will be split. If any mistakes are made during this process and either of them find themselves paying unnecessary taxes or penalties, the stress of their divorce will only be compounded.
At first, Lenny said he just wanted to give June a check for half of his IRA. Not a good choice, since this would be treated as a taxable distribution for Lenny, the IRA owner. I explained to them that to properly divide an IRA, they must have specific language included in their Marital Settlement Agreement (MSA) that clearly identifies how their assets will be divided. Once this agreement is completed and executed they must give a copy of it to their IRA custodian. Then, they need to open an IRA in June’s name and transfer half of the funds (if directed to by the MSA) from Lenny’s IRA to June’s IRA.
Lenny’s 401k must be treated differently than his IRA. A 401K is called a “Qualified Plan.” Qualified Plans, for the most part, are retirement plans established by businesses. (Both traditional and Roth IRAs, on the other hand, are set up by individuals.) Splitting a Qualified Plan requires a special court order, known as a “Qualified Domestic Relations Order” (QRDO). Once Lenny and June obtain a QDRO, Lenny will need to send a copy of it to his 401K’s plan administrator. The terms of the plan itself will dictate when June will receive her share of those funds.
As explained above, in order to receive funds from Lenny’s IRA, June must have an IRA set up in her name. Once we set up an IRA for June, funds must be transferred directly from Lenny’s IRA to June’s IRA. We always want to do what is called a trustee-to-trustee transfer to avoid any potential tax implications and the possibility of a 10% early distribution penalty.
I asked June whether or not she will be using the funds she will receive via their QDRO (from Lenny’s 401K) before she turns 59 ½. This is important to know because funds distributed from Lenny’s 401K under a QDRO are exempt from the 10% early distribution penalty even if June were to receive those funds directly, rather than having them transferred into an IRA. She would still have to pay federal and state taxes on any distribution, however, as explained above, QDRO distributions from a qualified plan are exempt from the 10% penalty. If, on the other hand, June rolls those funds over to an IRA from Lenny’s 401K under a QDRO, and then later takes a distribution prior to age 59 ½, Uncle Sam will come with his hand wide open and take that 10%. Not an outcome June wants, which is another reason it is so important to work with financial advisors who are experts in the areas of retirement accounts and proper methods of distribution from them.
I shared with Lenny and June one of the most common mistakes I see in my practice – clients whose former advisor failed to update beneficiary forms upon a divorce. This is not something that should be taken lightly. I gave them an example. About 6 months ago, I was performing a full financial review for a new client and his wife. They were recently married; she had never been married before but he had. Upon completion of my evaluation, I asked my new client if he still wanted his ex-wife to inherit $775K of his current IRA. I saw confused looks on both clients’ faces. Once I explained that is how his old advisor currently has his IRA set up, his new wife slammed her fist down on my desk and said, “She gets nothing!” Hmmmm. I don’t think that divorce was as amicable as my new friends Lenny and June’s divorce. This is just one of many cases where a failure to properly perform a beneficiary audit could lead to an unintended result, where an ex-spouse could receive funds that were intended for children or even a new spouse. Don’t let this happen.
I finished our meeting by advising Lenny and June to reassess their retirement and financial preparedness, because after reviewing their statements, it was evident that changes to their portfolio had not been made in quite some time. As I have said before, market corrections are inevitable after times of significant market growth and people must be prepared for them. I helped Lenny and June understand that capital preservation is the cornerstone of any successful financial portfolio and after dealing with such an emotionally draining and traumatic event, they should position themselves to avoid any additional problems that would result from a financial loss. There are solutions.
Be vigilant and stay alert, because you deserve more!
Jeffrey Cutter, CPA, PFS is the managing partner from Cutter Financial Group, LLC (www.www.cutter-copy.dev) which provides private wealth and financial management through low risk, low volatility successful investment solutions; securing peace of mind. He can be reached at jeff@www.cutter-copy.dev.
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