How Retirement Assets are Treated in Divorce or Legal Separation
Retirement assets are often the largest assets that parties own. Treating them correctly in a divorce or legal separation is crucial for each party’s future economic security.
- Three Kinds of Retirement Accounts
Retirement plans that pay future monthly benefits based, normally, on years of service and the high salary earned by the participant are called defined benefit plans. Most Washington state retirement plans such as PERS1 and PERS2 are defined benefit plans.
Retirement plans to which the participant contributes a fixed percentage of salary, and which grows in value (at least that is the hope!) as a tax deferred investment that will be paid back over time after retirement, is called a defined contribution plan. A 401(k) account is the most common kind of defined contribution plan that we see.
A third kind of retirement account is a tax deferred savings plan like an Individual Retirement Account (IRA) or a Washington State Deferred Compensation Account to which the owner can contribute varying amounts each month, or nothing, and can start and stop at any time.
There is, perhaps, a fourth kind of account - one having a defined benefit portion and a defined contribution portion. A Washington State PERS3 account is like this.
- Separate and Community Property Character of these Accounts
Retirement benefits and funds that were earned or contributed before marriage are separate property. Normally they are not divided and are retained by the party who accumulated them. The value of those benefits and funds at the time of divorce is still separate. Here is a simple example. If the wife had 1,000 shares of ABC, Inc. stock in a retirement investment at the time of marriage that was worth $10 a share, she brought $10,000 of separate retirement investments to marriage. If she still owns that stock at divorce but it is worth $50 a share then, she has $50,000 of retirement investments that is still separate property.
Retirement benefits and funds that were earned or contributed during marriage are community property. Normally they are divided between the parties. It does not matter who earned the retirement benefits or saved the retirement funds - these are community assets that belong equally to each of the parties.
- How Retirement Benefits and Accounts are Divided Between the Parties
a. Each Party Keeps His or Her Own Accounts
Some couples feel that should each keep what each has accumulated. They may not know what each party’s retirement benefits and funds are worth, and they may not care. For example, two government workers with similar salaries and similar lengths of service may feel this is simple and fair. A court would not treat their retirement accounts this way, but if the parties settle their case on their own, and this is how they want to treat their retirement benefits and funds, the court will accept this settlement.
b. Accounts are Given a Present Value and Divided Like Other Assets
Generally, community propertyas a whole is divided equally. It is not that each item is divided equally - the estate as a whole is divided equally. For example, if a couple has two large assets, a house and a retirement account, and one party keeps the house and all of its equity, the other party might keep the whole retirement account, if it is worth the same amount as the home equity. If it is worth more than the home equity, perhaps only the amount by which it exceeds the home equity will be divided. For the purpose of this kind of division, it is necessary to know the present value of the retirement benefits and accounts.
- Valuing a Defined Benefit Plan: The right to a stream of future retirement benefits has a present value that can be considered along with the other present property values. A simple description of this value is that it is the amount a person would need to have available today to invest to produce the same stream of benefits as the projected retirement benefits. The calculation of this amount is based on the projected monthly retirement benefits, the party’s age and life expectancy, and assumptions about investment rates. We have software that can calculate this figure, and all accountants can calculate this figure.
The amount of the participant’s contributions to the plan is absolutely not the present value of the future retirement benefits. This is the amount shown on most annual account statements. These contributions belong to the participant, can be withdrawn if the participant leaves employment, and would be paid to the estate on the participant’s death before retirement. However, if the participant retires, the participant will generally receive far more in retirement benefits over time than the value of his or her contributions.
- Valuing a Defined Contribution Plan: This is easier! It is worth what the account statement says it is worth. A common issue here though occurs when the value of the community share changes before the divorce is finished because of changes in the value of the investments. If those changes are merely due to market changes, not additional contributions after separation and not due to withdrawal, it is the latest possible date that should be used to value the asset that is being divided.
c. Retirement Benefits Are Divided When Received
This is considered by the courts to be the best method to divide defined benefit retirement plans because no assumptions, like a party's life expectance or a fair investment rate need to be made, as they are when a defined benefit plan is given a present value. (See the discussion above.)
An order can be entered as part of the divorce that does not say what the value is of the retirement benefits and accounts. The order simply divides the community share equally when the parties are retirement age and can begin drawing benefits. It does not matter what the benefits are worth now or will be worth in the future. For private plans, this order is called a Qualified Domestic Relations Order. (QDRO - which is pronounced quadro.) For government plans these are usually called Property Division Orders. These orders are very specific to each plan. Most plan custodians have a model order that they require, and the order will not be honored by the plan if it does not meet their requirements, even if it is signed by a judge.