Certain Tax Considerations in Transferring Retirement Interests

Transferring retirement interests pursuant to a divorce can allow the parties to shift the tax burden of some payments from retirement funds from one party to the other. Whether this is something the parties want to do or is reasonable in their specific case is a matter for their individual attorney to analyze.

Payments from a Pension Plan

Payments from a pension plan can typically be divided at the gross or net levels. While some plans have a different definition for “gross” or “net”, for purposes here “gross” means the largest, unreduced payment from the plan, prior to any deductions, and “net” means the smallest, most reduced payment from the plan, after all deductions.

If divided at the gross level, that means each person will pay tax on the funds they receive. This division type is most common because it is as if each party earned their share of the pension, and are paying taxes based on their own income level.

If divided at the net level, then the participant is paying taxes at their income level for the entire benefit, and the payment made to the alternate payee/former spouse is free and clear of any tax implications. This type of division is exceedingly rare. While the participant is responsible for all of the taxes, the alternate payee/former spouse’s share is reduced also by any other deductions the participant may elect, such as a survivor benefit cost for a future spouse, or health insurance or life insurance premiums. Typically this type of division is used when both parties are retired and the income amounts are already known and they prefer to divide their retirement income based on the figures they know. The alternative is that the income to the alternate payee/former spouse may be different than intended based on the alternate payee/former spouse’s tax bracket.

Transfers from a Defined Contribution Account (Traditional accounts only)

When transferring from one retirement account to another, so long as the receiving account is eligible (check with the financial institution to see if the account is eligible to receive the funds) there will be no tax payment triggered by the transfer. However, the tax must still be paid on the funds at some time, so under this scheme, the tax will be paid by the person receiving the funds, but at the time the person takes the funds out of their retirement account. Typically, this is when the receiving party is retired and using their retirement accounts for income.

A retirement transfer may also take place to access funds when no other more-liquid funds are accessible. In this case, if the alternate payee/former spouse has a lower tax bracket, it may make financial sense to transfer the funds out of the retirement account and have the alternate payee/former spouse take the funds as cash. In this scenario, the alternate payee/former spouse would pay tax on the transferred funds immediately (and reconcile it when filing their taxes for that year). When a transfer is done for this purpose it may be ‘grossed up’ to account for the tax payment, meaning the tax payment is effectively shifted from the alternate payee/former spouse to the participant. This is most likely when the transfer is coming from retirement for a non-retirement asset, such as a home interest buy-out.

Why Transfer Instead of Withdrawal?

In the last scenario, the retirement funds in exchange for the home interest, it seems somewhat illogical to add the step of transferring the funds to the alternate payee/former spouse to take as cash rather than having the participant take the funds out as a withdrawal. For parties that are not yet at retirement age, there is the early withdrawal penalty to consider. If the participant is not of age and withdrawal the funds directly, the early withdrawal penalty is applied. However, the early withdrawal penalty is avoided if the alternate payee/former spouse receives the funds as cash through a QDRO transfer. Note, this is applicable for 401k and other similar type of accounts that are governed by ERISA. It is not the case for non-qualified plans or IRAs.

Disclaimer: This firm focuses on the practice of family law and the information provided herein related to tax considerations is legal information and is not tax advice. You may want to consult with a tax professional for any specific questions related to your case and circumstances.

Further, not all plan types follow the rules described above. The plans described and rules referenced herein are for the majority of plans. You should review the rules for the plan in your case carefully to determine how it interacts with the tax laws.

Contact our office at 240-396-4373 for QDRO related assistance.