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Divorce Strategies Group

Denise French

401k

Lets Just Live Together

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We have 5 children in our blended family and now the first of them is about to hit his 20’s and looking for Mrs. Right, I’m concerned!!! Millennials and Generation Z young adults could be the first generations of children-of-divorce. By 1983, all but 2 states had adopted no-fault divorce laws and over the next decades, the divorce rate rose to our now norm of about 50%. That resulted in many of those kids watching their parents’ divorce and suffering the emotional consequences that often accompany that. When you really consider the early years, there were few resources available to couples and families on how to go through the process in the most humane way. But let’s face it, even with the resources today, there are still plenty of ugly divorce tales out there.

So, for a lot of these kids, as they grow past their 20’s and into their 30’s, a very interesting trend is persisting. The divorce rate, the number of divorces per marriages, continues to rise but the actual number of divorces each year is dropping steadily. Why is this? Because young people are not getting married! They are choosing instead to be in serially monogamous, long-term relationships, often including children and joint home purchases, but forgoing the tradition of a recognized marriage. I understand. They don’t want to go through what their parents went through so the heck with marriage! However, the result of this when life doesn’t go as planned can be disastrous. No burden of marriage also means no protections of marriage.

Consider this: Josh and Beth have been together 4 years and decide to have children. They agree that Beth will stay home and care for the kids while Josh finishes his degree and works nights to support the family. Once he’s done and gainfully employed, the kids will be a little older and Beth will then go back to school and finish her degree.

Well, life happens, and three years into this fabulous plan, Josh is about to graduate and drops the bombshell on Beth that he’s been having an affair with a fellow student. He’s in love and just can’t go on like this. He’ll be a good dad to their children but he’s leaving her. (Didn’t see it coming, did you?) Oh, and by the way, last year they bought a home but since Beth had no income, they didn’t want her low credit score to drag down their interest rate, so the house and mortgage are in Josh’s name.

So, what’s Beth entitled to?  She’s like entitled to child support. The house was purchased by Josh and now that Josh is about to finish school and have a great job he can move on with his life in house. But they had plans! They had an agreement and she sacrificed her education to pay for his! Too bad. Had they been married, she could have been entitled to half the equity in the home, possible reimbursement for half of his education expenses and a portion of anything they acquired during the marriage. But boy, isn’t she lucky that she doesn’t have to go through a divorce? Josh kicked her out a week later and she and the kids had to move home with her parents.

Now, Texas does recognize common law marriage, but you will likely need an attorney to determine if you are married or not. What does that mean for Josh and Beth? It means Beth hires an attorney to prove they were married while Josh hires an attorney to prove they were not – after they fight about being married or not they then go on to fight over the house, the debt, the kids and anything else they own. What does that sound like? It sounds like the litigated divorce the parties set out to avoid in the beginning by not legally saying “I Do”.

This is SO REAL!! We highly encourage young people who wish to cohabitate take the time to visit an attorney to walk through the legal ramifications of this prior to moving in together. A simple Cohabitation Agreement can change many things. There are free ones available all over the internet or you can visit a family law attorney for more specific advice pertaining to your set of facts. Never move in with someone without one! It could end up saving you your entire financial life.

The 401(k) Plan and Your Divorce

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Divorce itself is an emotionally charged, troubling process. When you add major financial decisions to the mix it can create a recipe for disaster. Our goal is to help litigants make sense of the financial maze they face in divorce and navigate the process with confidence.

401(k) and Divorce

A large portion of many divorce settlements we are hired to help with involve retirement plans. Per the Investment Company Institute, as of December 31, 2018, 401(k) plans held an estimated $5.2 trillion in assets and represented 19 percent of the $27.1 trillion in US retirement assets, which includes employer-sponsored retirement plans (both defined benefit (DB) and defined contribution (DC) plans with private- and public-sector employers), individual retirement accounts (IRAs), and annuities. In comparison, 401(k) assets were $3.1 trillion and represented 17 percent of the US retirement market in 2010.

The 401(k) and Divorce, Explained

It’s no surprise that retirement plans hold a large portion of discussions in divorce cases. Because this specific retirement plan is such a large part of so many divorces, we want to help the reader understand the composition of the 401(k), taxation of the 401(k), and the pros and cons of keeping or receiving this asset in divorce. There are three parts which comprise a 401(k) plan. Those parts are (a) employee deferrals, (b) employer matching contributions and (c) employer elective contributions or profit sharing.

Employee Contributions or Deferrals

This is the employee’s contribution into their own retirement plan and is 100% vested immediately. You keep your elective employee contributions no matter how long you have been with your employer. Taxation of your contributions depends on how you chose to contribute them. Here are four ways an employee can contribute to their 401(k) for tax purposes.

1) Elective, Pre-Tax Deferral Contributions
These are also called salary reduction contributions and are the most common types of contributions to retirement plans. You elect to have money deducted from your salary each pay period and contributed to your retirement account. Pre-tax dollars are contributed, which means that the money does not have any tax withheld from it before it is put in the retirement account. This can be a percentage of your pay or a set dollar amount each month. Money that is contributed in this way is not reported as taxable income. This helps decrease your taxation the year of contribution and your assets grow tax deferred. You are taxed on these assets when they are distributed as ordinary income.

2) Designated Roth Contributions
A designated Roth contribution is similar to an elective deferral, except the amount deferred is taxable as normal income prior to being contributed into the 401(k). You can again pay a set percentage of your salary or choose a set amount to defer each month. Your assets will grow tax deferred and this portion of the deferrals are tax free when distributed. There is just no tax benefit in the year of contribution.

3) After-Tax Contributions
Not all retirement plans allow after-tax contributions. These are generally non-Roth contributions that you choose to make in addition to your regular elective deferrals of salary. If your plan allows after-tax contributions, any contributions that you make must be included in your taxable income. After-tax contributions may not be deducted. We see this with highly compensated employees who wish to maximize their deferral limits up to the IRS allowable maximum each year. The contributions grow tax deferred. Earnings are taxed when distributed as ordinary income.

4) Catch-up Contributions
If you are at least age 50 by the end of the year, you may be able to make additional, nontaxable, elective deferrals beyond the basic limit on contributions. If your plan allows it and you qualify, you can make these contributions, up to the catch-up contribution limit, even if you have made regular deferrals up to the regular limit. Catch-up contributions are a good option for those who perhaps did not contribute a lot to their plans in the past, for those who waited until later in life to start saving for retirement, and for those who just want to ensure a comfortable retirement.

employer contributions

Employer Contributions

1) Matching Contribution
The second portion of the 401(k) is the employer matching contributions. This amount is also 100% vested no matter how quickly you leave your employer after receiving the contributions.
In most retirement plans, your employer can make contributions to your account on your behalf. In some plans, employer contributions are mandatory; in other plans, they are discretionary (optional).

Elective deferrals by employers are called matching contributions because the employer matches a certain amount per dollar contributed by the employee. For example, for a plan that is considered “safe harbored” the minimum an employer must match is dollar for dollar up to 3% of your salary deferrals and .50% for the next 1% and an additional .50% for the following 1% you defer of your salary. In this case, if the employee defers 5% of their salary into the 401(k) the employer will contribute 4% of the employee’s salary into the 401(k) for a total of 9% of the employee’s salary annually deferred. The employer can elect to contribute more or less, depending on how the plan is created and current IRS imposed rules. Matching employer contributions are not taxable income to the employee (though the amount may be shown on your W-2.) These funds grow tax deferred but are taxable to the employee when distributed as ordinary income.

2) Discretionary Contributions (Profit Sharing Plan)
Discretionary, or non-elective, employer contributions are the third portion of the 401(k) which are typically referred to as the Profit Sharing Plan portion of the 401(k). These are contributions made in addition to matching contributions, at the employer’s discretion. Such a contribution must be made equally to every employee covered by the plan; it cannot typically be made only to certain individuals. Discretionary contributions by employers are generally nontaxable income for you today, grow tax deferred but are taxed when distributed in the future to you as ordinary income. The Profit Sharing Plan portion typically has a vesting schedule which can either be a three-year cliff vesting or a certain amount of years vested schedule. Three-year cliff vesting means the employee is 0% vested until the 3-year mark of employment. Yearly vesting schedule means you are vested a certain amount each year such as 20% per year for 5 years and you are fully vested after 5 years.

QDRO edit

Qualified Domestic Relations Order (QDRO)

A Qualified Domestic Relations Order (QDRO) is the federally mandated tool utilized to move a 401(k) from one spouse to another spouse as part of a divorce settlement. When moving funds, the recipient spouse can receive the 401(k) funds in one of three ways: (a) cash, (b) another 401(k) or (c) their own Individual Retirement Account (IRA).

Cash

It is quite common that the 401(k) is the largest cash asset in a couple’s estate and one party will need funds to help them after the divorce for the purchase of a new home, living costs or attorney’s fees. It is so common to use these funds in a post-divorce situation; the IRS offers a penalty to break for cash from a 401(k) specifically pursuant to divorce.

If you move funds from a 401(k) to cash you will be taxed on the funds as ordinary income (as if you had a job that earned as much as you are receiving in cash) as well as an additional 10% penalty if you do not meet certain exemptions which include being age 59.5 or older, death, disability, or 72(t) systematic withdrawals or receiving funds via a QDRO.

If you need cash you will be taxed on any non-ROTH 401(k) funds you receive, but you will NOT be penalized the additional 10%. For example, Sue and John divorced. John has $800,000 in his 401(k). Sue received 50% of that asset. Sue needs $200,000 to purchase a home. Sue was advised by her CPA to redeem $250,000 from the 401(k) in cash. $50,000 of that was sent directly to the IRS for taxation and $200,000 was put into Sue’s bank account. The remaining $150,000 was sent to Sue’s own IRA. That $150,000 was not taxed nor penalized. That portion became Sue’s own IRA and was treated as such going forward.

QDRO Funds to a 401(k)

If you move funds from a 401(k) to another 401(k) you will not be taxed or penalized. Some plans will allow you to stay in the current 401(k). We do not typically recommend this as it’s tethering you to your ex-spouse and your old life. You can typically purchase the same investments in your own IRA. Some plans will allow you to roll the funds into your own 401(k). We also typically do not recommend you roll the funds into your own 401(k) because it limits your investment options. If you roll the QDRO funds not your own IRA you have a greater mix of funds to choose from or at the least, a different mix of funds to choose from and you can do it often without the 401(k) administrative fees.

QDRO Funds to an IRA

If you move the QDRO funds into your own IRA it will be done without taxation or penalty. You will create your own Individual Retirement Account and it will be treated as one you created from inception. Your ex-spouse is no longer a part of this; it’s your own account invested as you see fit. If it is in an IRA, you will have no constraints on your investment selection. We advise you consult with an experienced financial advisor to help you invest according to your own goals, time horizon and risk tolerance when determining how to invest any divorce process.

Summary

The 401(k) is a wonderful tool to help build wealth. When you are awarded one or a portion of one in divorce it can help you in a tremendous way either today with cash flow or in the future for our own retirement. We can help you in a variety of ways with the financial portion of your divorce settlement. Call our office for a complimentary consultation to discuss your specific needs, goals and circumstances. Contact us to schedule your personalized meeting.