A qualified pension plan is different from an IRA, specifically by the tax treatment. I’m going to refer to this not as a pension plan for this question but for saving, such as a 401K.
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 percent. 3 percent, 4 percent, 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.
When you put money into an IRA, you’ve already paid taxes on that money, so while the interest you are accruing on that IRA, you’re putting that money in and you’ve already paid the taxes on it. So you see how it’s already the tax treatment.
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, 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, and that’s 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. However, if they withdraw the money, they’re going to have tax consequences on that money. Now that’s if they’re taken from a qualified plan.
If we are dividing an IRA, it’s different. Some IRAs do require a QDRO, some do not. However, if you are under 59 and a half, you’re going to get your money if you cash it out, you’re going to have your tax consequences plus you’re going to have a 10 percent penalty and that is the difference. 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 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 a 33 percent tax bracket, federal, and then I’m looking at their state tax bracket and then they’re going to pay another 10 percent penalty, they could be looking to pay a significant portion of their IRA that they’re going to lose to taxes and penalties, and it doesn’t make sense. For that client I would encourage that client to reinvest that money and avoid that downward spiral of the money.
Something else to look out for when you’re in a divorce is, if your spouse has a 401K, 403B, one of these qualified plans, and they change jobs, the job is going to dictate that they may have to remove that money from the 401K, the 403B, and then roll it into an IRA. If they do that, what’s going to happen if you were depending on that money, now you’re looking at an additional 10 percent penalty. If I see that coming I would write to the plan and see what I can do to see if we can keep that money in the plan till 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.