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What you should know about retirement accounts and divorce?

Couples that are going through a divorce and have money invested in retirement plans will typically be required by the court to share these assets between them. In some cases, these shared assets may be given to one of the parties instead of being split between both parties. In these situations, having a proper understanding of the rules that govern asset division in a divorce may be helpful.

The type of retirement plan ultimately determines what rules come into play that govern asset division and tax liability. Retirement plan types are generally either individual retirement accounts (IRA) or a qualified plan. Regardless of whether bother parties plan to split their assets in their respective IRAs and qualified plans identically or not, a separate legal term is required for each type of division. The process used for splitting IRAs is called "transfer incident to divorce" while the process used for splitting qualified plans is called "qualified domestic relations order" (QDRO).

The main benefit to requiring an IRA division to be treated as a transfer incident to divorce in a divorce or separation agreement is that no taxes will be assessed on the transaction. The original IRA account owner will not owe any taxes on any funds that are transferred over to the recipient. The funds transfer will be classified as either a transfer or a rollover by the respective IRA custodian. The classification that the IRA custodian uses will be determined by the specific circumstances of the division and how the divorce decree is worded by the court. After the transfer is complete the recipient assumes legal ownership of the assets and consequently full responsibility for any and all tax consequences of any future transactions. If however the wrong process is used instead of a transfer incident to divorce, then the original IRA account holder will end up owing taxes on any transferred funds as well as accruing an early withdrawal penalty fee.

Typically qualified retirement plans are protected by law from seizure claims or attachment by creditors but are not exempted from such claims by a divorced or soon to be ex-spouse if the ex-spouse uses a QDRO. This is the only lawful way to divide qualified retirement plan assets. QDROs are similar to transfers incident to divorce in that they are tax-free transactions. The recipient may roll QDRO assets into their own qualified plan or into a traditional or Roth IRA if they choose to.

Source: Investopedia, "Divorcing? The Right Way to Split Retirement Plans," Mark Cussen, Accessed Sept. 23, 2014

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