One of the largest and oftentimes most difficult items to separate during a divorce are retirement plans. Valuing and dividing these assets can be challenging, particularly when one spouse began participating in the plan prior to the marriage. A financial expert can assist divorcing couples in valuing retirement plan assets and determining the extent to which contributions, earnings, distributions and loans constitute separate or marital property.
To divide or not to divide
One critical question to answer is whether a couple will divide retirement benefits between them, or whether they’ll leave the benefits with the participant spouse and distribute other assets to make up the difference. Either approach requires a valuation of the plan. In addition, the financial expert needs to determine the spouses’ respective interests in the plan.
Dividing benefits in a qualified retirement plan generally requires a Qualified Domestic Relations Order (QDRO). Ordinarily, these plans prohibit a participant from assigning his or her benefits to someone else. If the participant violates this provision, the amount assigned will be treated as a taxable distribution. Benefits assigned pursuant to a QDRO are an exception to this rule. To be effective, a QDRO must contain specific information and language, so it must be drafted carefully.
Defined-contribution or defined-benefit plan
Determining the value of a defined-contribution plan — such as a 401(k) or another profit-sharing plan — is relatively simple. Generally, the value of the participant’s benefit is equal to his or her account balance on the valuation date.
Valuing a defined-benefit plan — such as a traditional pension plan — is more challenging. Typically, a valuator determines the participant spouse’s accrued benefit using a formula based on years of service, average earnings and other factors. But the accrued benefit on the valuation date is only part of the story.
To get a more accurate picture of value, a valuator must project the participant spouse’s monthly income stream beginning on the expected retirement date, use actuarial valuation techniques to convert that income stream to a lump-sum value at retirement, and then discount that amount to present value as of the valuation date. The valuator also might reduce the value to reflect the risk that the participant spouse won’t reach retirement age.
For either a defined-contribution or a defined-benefit plan, if benefits are subject to a vesting schedule, the valuator also adjusts the value to reflect the risk that unvested benefits won’t be received.
Marital or separate property
Allocating retirement benefits between separate and marital (or community) property can be a difficult task. In most equitable-distribution states and in many community-property states, benefits a participant spouse earned or contributions he or she made before marriage are separate property and, therefore, aren’t divisible in divorce.
One method of distinguishing between marital and separate property is simply to divide the length of participation in the plan during marriage by the length of participation overall and multiply that fraction by the benefits’ value. But this approach can yield inaccurate results. Contributions made (or benefits accrued) early in one’s employment tend to be smaller, because they’re usually based on a lower salary. An alternative approach is to trace the actual value of contributions made (or benefits accrued) both during and outside of marriage, although this method is more difficult.
Another challenge for defined contribution plans is accounting for investment gains and losses (appreciation and depreciation) during marriage. Some of those gains and losses might be attributable to contributions that pre-date the marriage, while others might be attributable to contributions made during marriage. In some states, appreciation on separate property during marriage is considered marital property. Other states make a distinction between passive and active appreciation, treating passive appreciation as separate property and active appreciation as marital property.
Passive appreciation is an increase in value as a result of market forces, such as supply and demand, or inflation. Active appreciation results, in part, from the efforts of one or both spouses during marriage. In most cases, retirement plan asset appreciation is passive, although some active appreciation may occur if the participant is involved in managing the account’s investment portfolio.
Ideally, a valuator would calculate the actual gain and loss on individual contributions, but this may be extremely difficult — or even impossible — depending on the information available and the extent to which the investment portfolio has changed over time. A simpler approach is to allocate portfolio gains and losses based on the average ownership percentage (marital vs. separate) during the marriage.
Distributions and loans: Marital or separate?
Allocating retirement benefits between separate and marital (or community) property can be challenging. What happens if the participant spouse took distributions from the plan or borrowed money against the plan during the marriage? The answer depends on how the funds were used and, in the case of a loan, whether it was paid back.
Generally, distributions during marriage are presumed to reduce the marital or community interest in the plan. But a distribution may be treated as reducing the participant spouse’s separate property interest in the plan if the spouse used the funds to acquire separate property or pay expenses (a mortgage, for example) related to separate property.
Expert or amateur
Dividing retirement benefits in divorce is a complex undertaking. A financial expert with valuation and forensic accounting experience can help value benefits and classify them as marital or separate property. To learn more, contact your Windham Brannon advisor today, or reach out to Matt Stelzman.
