What’s the difference between an IRA and a qualified pension plan?
An Individual Retirement Account (IRA) is different from a qualified pension plan specifically because of the tax treatment. For this question, I’m going to refer to the qualified pension plan as a savings plan, such as a 401K (a retirement savings plan sponsored by an employer).
When you put money into a 401K from your paycheck, it is tax deferred—you don’t pay any taxes on that money. You get it completely tax free. Your employer may match it—2%, 3%, 4%, whatever the plan provides, and then you get to save that money and let it build in accordance with the market. It’s completely tax deferred, until at some time point in the future, when you are permitted to withdraw that money.
I’d like to address the difference in the way we divide a qualified account from a non-qualified account, in divorce. For example, when dividing a 401K we use an instrument called a qualified domestic relations order. Some people call it a cue-dro, some people call it a qua-dro (QDRO), but, essentially, this is an instrument that we use to divide a tax deferred account so that when your spouse has been saving money in a tax deferred account, that account can only be divided in a certain fashion by a QDRO.
The alternate payee (the spouse that is not named on the plan) receives his or her share of the plan through this QDRO. Now, when the alternate payee receives his or her share of the 401K, 403B, profit-sharing plan, whatever that particular plan is, they will receive their benefit tax free. However, if they roll it over into an IRA by way of a QDRO, that money will go into the IRA without tax consequences. But if they withdraw the money, they’re going to have tax consequences if they’re taken it from a qualified plan.
If we are dividing an IRA, it’s different. Some IRAs require a QDRO, but some do not. However, if you are under 59 and a half, you’re going to have tax consequences if you make a withdrawal. In addition, you’re going to have a 10% penalty. That’s why it’s so important to know what kind of plan we’re dividing, because if I have a client who was waiting for that money and they’re saying, “I’m going to cash this out,” I would say to that client, “well, wait a minute, what are your tax consequences? Where do you fall on tax consequences?”
If I have a client that is in a federal 33% tax bracket, and then I look at their state tax bracket and they’re going to pay another 10% penalty, they’re going to lose a significant portion of their IRA to taxes and penalties, so withdrawing money from their IRA doesn’t make sense. I would encourage that client to reinvest the money and avoid that downward financial spiral.
Something else to look out for when you’re in a divorce is if your spouse has a 401K or a 403B. If your ex-spouse has one of these qualified plans, and for whatever reason they change jobs, your spouse may have to remove that money from the 401K or 403B, and then roll it into an IRA. If this is the case, what’s going to happen if you were depending on that money? You’d be looking at an additional 10% penalty due to the switch. If you’re in a situation like this, I would write to the plan and see what can be done to keep that money in the plan until the divorce is finalized.
It’s important that clients are aware of the different plans, the tax consequences of these plans, as they do their retirement planning as well as their divorce planning, when entering into a marital settlement agreement.
New Jersey attorney Cynthia Ann Brassington is certified by the Supreme Court of New Jersey as a Matrimonial Law Attorney, and regularly helps people to resolve their divorce-related issues, from property division, to child support, and custody. To learn more about Cynthia and her practice visit www.LinwoodFamilyLaw.com.