Many clients come to us asking whether they can keep their 401(k) in a divorce. Texas uses the law of community property to divide assets in a divorce. If the 401k was contributed to during the marriage, it is a marital asset. All marital property is community property and divided equally between the spouses.
The spirit and intent of the law are to reduce arguments in the divorce process. In practice, there are very few things that are as simple and neat as a straight 50/50 split of a 401k account. While community property is the black letter rule, there may be a part of your account that can stay yours, while the other part is divided.
- 401k Division in a Community Property State
- Dividing 401k Gains
- QDRO to Divide the Account
- Alternatives to Dividing a 401k
- Do Not Forget Taxes on the Account
- Get Help with Your 401k and Divorce
401k Division in a Community Property State
In a Texas divorce, there is always a question of what is individual property versus what is community property. Separate property includes the assets that each spouse had before the marriage started.
The date of the marriage begins a different treatment of the new assets contributed to the account. The part of the account that they owned before the marriage is separate property. Any contributions that were made to the 401(k) account during the marriage is considered part of the community.
The date of the marriage begins a different treatment of the new assets contributed to the account.
Complications arise when both spouses continued to contribute to the account during the marriage. This is because spouses may not always be able to prove what and how much they brought into the marriage. This is especially true if the marriage lasted for a long time. Each spouse may not have the records to show what the account balance was at the time they got married.
Further, people switch jobs, and they roll their 401(k) accounts over to new sponsors. Thus, they may lose records that they may need to prove that the property was separate. Also, it could be difficult to go back in time years or decades to sort this information out. Thus, community property laws are not as seamless as one may think. In this case, Texas law may make things even more complicated.
Dividing 401k Gains
In addition, a 401(k) account could increase substantially during the course of the marriage. Over the past 50 years or so, the stock market has increased an average of roughly 10 percent per year. With the compounding of money, a retirement account could increase multifold during a marriage. The question is often what happens to the gains during the marriage and who gets them. The gains in the value of community property would be subject to division upon divorce.
The gains in the value of community property would be subject to division upon divorce.
Accountants May Need to Trace the Account
As you can see, the topic of division of how a 401(k) is divided in a divorce complex. In Family Code Section 3.007, Texas law states that:
“The separate property interest of a spouse in a defined contribution retirement plan may be traced using the tracing and characterization principles that apply to a nonretirement asset.”
The Subtraction Method
According to a 1973 case, the gain in value for stocks during the marriage that were owned prior to it are considered separate property. However, some courts have ruled that the separate property portion of a 401(k) account should be determined by subtracting the value in the account at the time of marriage from the value of the account at the time of divorce. This method, known as the subtraction method, would take the gain in value of the account during the marriage and subject it to division.
The Texas Legislature added the Family Code Section 3.007 language above in 2005 because the subtraction method took away property that may have constitutionally belonged to one spouse. Texas law now makes it clear that the same principle applies to retirement accounts.
The word “tracing” in Section 3.007 means that you may need to go through a complex accounting process to figure out who is entitled to how much of a 401(k) account. It may be difficult to trace the gain attributed to the separate property, especially if the account holder made any changes in allocations during the course of the marriage.
If you are not able to reach an agreement with your spouse, or even if you want a basis to negotiate, you may need to hire forensic accountants to trace the value of the separate and community property. The judge will make the ultimate decision if the two parties cannot agree on dividing a 401(k) account.
You Need a QDRO to Divide the Account
Once the court divides the 401(k) plan, you would still need to take further administrative steps to actually divide the account. The spouse who is entitled to receive part of the other spouse’s retirement plan must have the court enter a Qualified Domestic Relations Order (QDRO). That’s because the 401(k)’s plan administrator needs to be compelled by the court to physically divide the account and give the other spouse their share. The QDRO would set forth the basis for the division and how it is to be calculated.
A QDRO is not necessarily something that lends itself well to the same template form each time. The plan administrator needs to see certain language in order for the QDRO to be valid. Once the plan administrator receives the QDRO, they can perform the physical division.
With respect to dividing a 401(k), nothing is final until this document is executed.
Given the importance of this document, you should seek the help of an experienced family law attorney in drafting and executing it. With respect to dividing a 401(k), nothing is final until this document is executed. If a spouse waits months after the divorce to execute the QDRO, they may simply not be entitled to any gains in the account in the meantime.
Alternatives to Dividing a 401k
While community property should be divided in half, there are creative ways to do this. You may want to keep your entire 401(k), but your spouse would still be entitled to their portion of the community property. You may be able to give your spouse another asset or a higher proportion of another asset, so the overall assets are divided 50/50 without giving up your retirement savings.
For example, the other spouse may be able to take more equity in the family home, and you can keep a larger part of your 401(k). Everything is subject to an overall negotiation, provided that the legal principles of community property apply.
Do Not Forget Taxes on the Account
The spouse who receives part of the retirement account also inherits the obligation to pay taxes on the money when they redeem it. This fact is something that should be considered in the divorce negotiations. If one spouse inherits a substantial tax obligation, they should make it up elsewhere in the amount of assets that they receive. Oftentimes, people do not realize that they will likely owe federal taxes on 401(k) money in the future. In addition, a spouse cannot have access to the money before they reach the relevant age, or else they would be required to pay an early withdrawal penalty.
In fact, taxes are one of the most common grounds for dispute when it comes to dividing a 401(k). The spouse who owns the account will argue that it should be valued at a lower amount because of the tax obligations. In other words, if the account has a paper value of $1 million, it may only really be worth $700,000 after accounting for the taxes that the account owner must pay. Even the tax rate by which the account is discounted could be a subject of disagreement.
Get Help With Your 401k and Divorce
The family law attorneys at Terry & Roberts can assist you with a high net-worth divorce attorney from start to finish. Regardless of what is at stake, you need legal help to ensure the best possible result. Do not assume that the laws of community property will automatically lead to the same result every time. No matter what, you should hire a lawyer to look out for your legal rights. To speak with a high net worth divorce attorney, reach out to us. When there are assets on the line, you should not take divorce-related legal matters into your own hands.