Along with causing emotional and financial upset, divorce can also have an enormous effect on retirement savings. That’s especially true if, within the marriage, there was a significant earnings imbalance. For example, if one spouse earned substantially more than the other, or one spouse took time out of the workforce to raise children.
While you’re going through the divorce process, retirement might be the last thing on your mind. But the decisions you make now will affect your long-term financial future. And splitting things down the middle may not actually result in equal assets when it comes to retirement accounts.
That’s why you want to make sure you fully understand all of the current and future implications of retirement and divorce, including how both will affect the assets you’ll have for your future. Here are a few key issues you’ll need to become familiar with.
“Grey Divorce” Numbers Are Soaring
Grey divorce, meaning divorce among couples where at least one spouse is 50 or older, is becoming more common all the time. It accounts for around 36% of all divorces in the U.S.
In any divorce, dividing up assets reduces the amount each spouse has available to fund their retirement. Selling off assets like investments or the family home can also lead to losses that wouldn’t have otherwise occurred. Supporting two separate households also costs more, depleting retirement savings even more quickly. And the legal costs of divorce, can run as high as $30,000 to $50,000. That’s especially true if there are a lot of shared assets or the divorce is combative.
In grey divorces, all of these financial setbacks are happening later in life, sometimes after one or both spouses have retired. That makes it harder to recover from divorce-related financial losses. Statistics show that women are financially hit much harder than men during grey divorces, with an approximate 45% drop in their standard of living compared to just 2% for men.
If you’re planning or going through a grey divorce, make sure you have a complete understanding of your current finances and how you can expect them to change. There are ways to split assets that can benefit both parties from both a tax perspective and a future growth perspective.
Don’t rely on your divorce lawyer for financial advice here. That’s not their specialty. Instead, work with a financial advisor who specializes in grey divorce to minimize the financial toll on you.
QDROs Are Crucial
Like all other assets in a divorce, retirement savings normally get divided. How the money gets split depends on a variety of factors, from the presiding state law to relative income levels. Regardless of how the numbers work out, it’s important to follow all the steps necessary to split the assets without triggering current income taxes and tax penalties and losing a huge chunk of that money as a result.
A QDRO (qualified domestic relations order) is a special legal document that spells out how employer-based retirement plan assets will be split in a divorce. The court issues a QDRO and serves it to the employer of the spouse with the retirement plan that’s getting divided. That way, the spouse with the plan won’t have to pay income taxes on the withdrawal.
Plus, a properly written QDRO prevents the 10% early withdrawal penalty that normally hits distributions from retirement plans taken before age 59.5. With a substantial retirement nest egg, that 10% penalty could be an enormous amount. For example, on a $500,000 retirement account, the penalty alone would come to $50,000!
NOTE: QDROs do NOT apply to IRAs (individual retirement accounts). Those are spelled out in divorce agreements. The splits are carried out as “transfers incident to divorce” to avoid triggering taxes or tax penalties.
Get the Wording Right
QDROs must contain specific language and information to be valid and to avoid that nasty 10% penalty. A proper QDRO must include the following:
- The plan owner’s name and mailing address (the spouse with the account)
- The alternate payee’s name and mailing address (the spouse getting the payout)
- The percentage or dollar amount of funds going to the alternate payee
- How the percentage or dollar amount was determined
- How and when the payments will be made
- How many payments will be made
You can find more details about QDRO language on the US Department of Labor website.
Complications with Defined Benefit Plans
Creating a QDRO for a defined contribution plan like a 401(k) is straightforward. Things get more complicated when defined benefit plans, also called pensions, are involved.
The calculations for defined benefit plan payments are complex and based on a variety of factors, such as length of service and life expectancy, for example. So the QDRO calculations usually require an actuary or other retirement benefit specialist to figure out each spouse’s fair share of the plan assets. On top of that, the payout terms in the QDRO can’t be different from the plan’s own payout terms, which are typically quite detailed for pensions.
Now or Later?
Many divorced people who receive payouts from retirement plans don’t put that money back into retirement savings. Instead, they use the money to cover current expenses.
If the money isn’t put into a retirement account, it will be subject to current income taxes, unless the money has come from a Roth account (more on this in a moment). For example, if one spouse receives $50,000 from the other spouse’s plan and doesn’t roll it into a retirement account, the plan manager will automatically withhold 20% for federal tax purposes. That’s to cover the expected federal income taxes on the $50,000, which depend on that spouse’s personal financial situation at tax time.
But if that money goes straight into a retirement account, income taxes won’t apply until the money is eventually withdrawn. That offers two important financial benefits:
- The money will have a chance to grow into a more sizeable nest egg, thanks to tax-deferred compounding
- The eventual withdrawals will be smaller than the original lump sum, reducing the tax burden
More important: It would be nearly impossible to regain the same level of retirement savings if the money is used now instead of stashed in a retirement account. Even saving up another $50,000 (or whatever the amount) over time wouldn’t give your retirement savings the same momentum. And a great deal of potential growth compounding time would be lost.
The Roth Factor
When splitting retirement accounts, remember that they’re not all treated the same for tax purposes. How the account will be taxed in retirement can significantly change its fair value. That’s because qualified withdrawals from Roth accounts won’t be taxed at all. But qualified withdrawals from traditional pre-tax accounts will be taxed in the year of distribution.
That means, for example, a $50,000 Roth IRA will be worth more than a $50,000 traditional IRA. Because the Roth IRA funds will be tax-free during retirement and the traditional IRA funds will be taxed. Depending on your tax rate, that could cost anywhere from 10% to 37% for federal income taxes alone.
Bottom line: A $50,000 Roth account is worth $50,000 in retirement. A $50,000 traditional account is worth at most $45,000… if you’re in the lowest tax bracket and live in a state that doesn’t tax retirement income.
Social Security and Divorce
If you’re divorced, you may be entitled to receive Social Security retirement benefits based on your ex-spouse’s earnings. Qualifying for the benefits depends on your specific situation and whether you meet the following conditions:
- You’re at least 62 years old.
- You were married for at least 10 years and have been divorced for at least 2 years (unless your ex is already collecting Social Security benefits).
- You’re not married (it doesn’t matter if your ex is married).
- Your ex-spouse qualifies for Social Security retirement benefits (even if they haven’t yet applied).
- The benefits you’d get based on your own work history are less than the benefits you’d get based on your ex’s work history
If you meet all of those criteria, you’ll receive up to half of your ex’s full benefits. The benefits you get have no effect on the benefits that your ex-spouse gets. The opposite holds true too: If your ex-spouse claims Social Security based on your benefits, it won’t have any effect on yours.
Also, neither of you can keep the other from collecting those ex-spouse benefits. In fact, your ex doesn’t even need to know that you’re claiming benefits based on their earnings history.
If you’ve been married and divorced more than once, you can choose whichever Social Security benefit gives you the biggest payout: yours or any of your exes’ benefits.
To avoid getting reduced retirement benefits, wait until you reach your full retirement age (FRA). While you can start getting Social Security payments at age 62, the monthly check will be smaller than if you wait until at least your FRA to start. Your FRA is based on your birth year, and you can find that information on the Social Security website. For anyone born in or after 1960, the FRA is currently 67.
Retirement and Divorce Can Be… Complicated
There is nothing easy about divorce, even in the best of circumstances. Andwhen you consider how divorce can affect your future, especially when it comes to the nest egg you plan to live on someday, it can get even more messy.
As hard as divorces can be, you need to protect your own future, as well as that of your children, if you have them. None of us know what the future holds. Take the time to consider how you will deal with your retirement assets if you are going through, or are planning to ask for a divorce. That way, you know you’ve got something to live on.
There is a lot to planning for retirement, regardless of your relationship status. Far more than I can get into in this blog post.
In my book Retirement 101 v2, I show you how to build that comfortable retirement nest egg, as well as how to plan for your largest expenses. I also explain how to stretch your retirement savings as far as possible, and how to deal with difficult situations, like retirement and divorce.
The best way to plan for your future is to know what to expect and how to adjust when changes come. This book can help you do that.
That way, when you’re ready, you have what you need to enjoy the rest of your life, regardless of what you may have already been through.
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