Many clients come to us asking whether they can keep their 401(k) in a divorce. Like all other marital property, retirement accounts are part of the community, and they are divided equally between the spouses. While that is the black letter rule, there may be some complex issues with 401(k)s, especially when each spouse had their own retirement account prior to getting married. There may be a part of your account that can stay yours, while the other part of it would be divided. What makes things even more challenging is that the retirement account could be one of a number of assets that are subject to division.
Even if you cannot touch the money in a 401(k) without penalty for many years, this account still has great importance to you. For many people, their retirement account and home constitute the bulk of their assets. This represents the funds that you are counting on in order to retire. The same holds true for both spouses. One spouse may not be working, or they are not earning as much as the other spouse. Thus, they are relying on the money in the other spouse’s retirement account to help them retire too. At the same time, the spouse with the larger 401(k) feels attached to the money because they have been saving for retirement for a number of years as a result of the time they’ve spent in jobs that have given them the opportunity to invest in a 401(k).
People Have Larger 401(k) Accounts These Days
These days, people are getting married later in life. Due to the divorce rate, many people are getting married for a second or subsequent time. Whatever the reason, many people enter a marriage with a sizable retirement account. In other cases, stock market gains have enabled a couple to amass a substantial amount of wealth in retirement accounts. Putting aside recent market turbulence, by many measurements the stock market has more than tripled since the end of the Great Recession, and many people are sitting on large paper gains in their retirement accounts.
How Texas Law Divides Retirement Accounts
Many people think of their 401(k) as theirs. However, if the assets were contributed to the account during the marriage, the account is not “yours” per se. Instead, it is a marital asset to which both spouses are entitled upon divorce.
Texas uses the law of community property to divide assets in a divorce. The spirit and intent of the law are to reduce arguments in the divorce process. In practice, there are still many things that could spark disagreements. Especially when someone wants to protect their 401(k), there are very few things that are as simple and neat as a straight 50/50 split.
The Concept of Separate Property Applies to a Retirement Account
In a community property state, there is such a thing as separate property. This includes the assets that each spouse had before the marriage started. They may have had their own retirement accounts that they continue to contribute to during the marriage. The complication is that they often have the same account before and during the marriage. The date of the marriage begins a different treatment of the new assets contributed to the account.
In a Texas divorce, there is always a question of what would be considered individual property versus what would be considered part of the community estate. Spouses may not always be able to prove what they brought into the marriage, especially 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.
How Separate and Community Property Are Calculated
It can be difficult to calculate how to properly divide retirement accounts like 401(k)s when a spouse has continued to contribute to the same account they have had since before getting married. The part of the account that they owned beforehand would be considered separate property, while any contributions that they made to the 401(k) account during the marriage would be considered part of the community.
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 increase 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.
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.
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. 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.
A Prenuptial Agreement Could Alleviate Stress
Spouses who have significant assets prior to their marriage should consider a prenuptial agreement to protect themselves in the event of a divorce. The agreement could dictate the terms of any divorce ahead of time and lay ground rules for the division of the assets. While Texas is a community property state, the two spouses are free to agree to their own alternative terms if there is a divorce. A prenuptial agreement could make things simpler and less contentious in the event of a divorce in many ways, including when it comes to dividing one or more 401(k)s.
Contact a Brazoria County Family Law Attorney Today
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.