Divorce Pitfalls: Dividing Retirement

I am often asked about the most common mistakes that I see in divorces.  This series of Divorce Pitfalls will cover the most common mistakes as well as how to avoid them.  Our first installment is one of the most common mistakes I see from both lawyers and parties: division of retirement accounts.  Mistakes in retirement division can cost you tens of thousands of dollars in taxes and in lost income later in your life.

Types of Retirement Accounts:

In order to understand retirement division, first you have to understand different types of retirement accounts.

IRA/401k:

These are known as “qualified accounts”.  They are called that because they are subject to strict rules from the IRS on taxation and use.  These funds are “pre-tax money”.  That means that you were not taxed on that money when it was put into the savings account.  You WILL be taxed on that money when you spend it.  Important things to know:

  • When you pull the money from these accounts to spend you will be taxed at your income tax rate that year.
  • If you pull out the money before you reach the qualifying age then you are subject to a 10% penalty in addition to the income tax.
  • In a divorce property division these funds are NOT EQUAL to cash. If you are trying to balance them with cash, then the value of the retirement funds needs to be reduced for the taxes and penalties.

ROTH Accounts:

A ROTH account is one of the best investments you can have.  The funds in these accounts are “post-tax money”.  That means that you have already paid taxes on the money that goes into these accounts.  They will continue to grow over time.  Important things to know:

  • When you pull money from these accounts to spend you will NOT incur any additional income tax for that money.
  • When you pull the money you will NOT incur any capital gains tax for the growth in the account since you invested the original funds.
  • When you pull the money you will NOT incur a 10% penalty (as long as you meet certain criteria).
  • In divorce property division, these funds should be considered equal to cash in their value because they do not have any additional taxes or penalties.

Pension (in Colorado the most common is PERA)

Pensions are not retirement accounts in the same way as IRA/401k or ROTH.  Those accounts have actual money and value that can be used now.  An employee does not have any current right to money from a pension unless they are already in pay-out status.

A pension is a system where you and your employer contribute to a fund that is run by the employer.  You don’t have a designated amount of that fund that is yours right now that you can access right now.  Instead, the employer promises that they will pay you an income after your retirement.  These are becoming very rare from private companies.  However, public employees in Colorado still get a great pension from PERA.  Important things to know:

  • Because a pension has no current cash value that can be removed, it is NOT EQUAL to cash.
  • We often have a financial professional provide a current value of the pension that can be included in the division spreadsheet.
  • Pensions can be divided between the spouses using something we call the Hunt When this occurs, the spouse who is not earning the pension will receive the proportionate share directly from the pension provider.  This will happen when the pension earner retires and starts pulling on the pension.

Apples to Apples

It is very important that you value assets in a divorce so that they are functionally equivalent to each other.  You do not want to give the same value to an IRA that still has to be taxed with a mutual fund account that does not have any tax consequences.

There are a variety of ways that we can reduce the agreed value of an asset in a divorce agreement.  These include formulas that reduce the value of the qualified assets or pensions by the estimated taxes and penalties.

If you had retirement assets before you got married, then you want to ensure that you claim that as your separate property.  Learn more about separate property at our blog Separate Property in Divorce: Keeping What Is Yours, and Divorce Pitfalls: The Three Biggest Mistakes with Separate Property

This process can be intimidating and overwhelming even to attorneys.  If you want to ensure that your retirement assets are correctly divided, then Contact Us today to talk to an experienced and compassionate attorney.  Let’s create solutions together.

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