Laura answers reader questions about 401ks and 403bs, including what happens to your account if you get divorced, how to handle a retirement provider that doesn't seem reputable, and how to pay taxes when you convert a traditional plan into a Roth IRA.
One of the best ways to save money and pay less tax is to invest through a 401k or a 403b retirement plan at work. But these accounts can be complicated because they’re loaded with strict rules created by the IRS.
I’ll answer several questions about workplace retirement plans that I recently received.
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Retirement Question #1:
Renier asks, “I’m wondering what happens to your retirement account if you get a divorce. I’m not married yet, but will be in the not-too-distant future and have never heard this topic discussed before. Does your retirement account stand alone or get divided up in a divorce?”
Answer: The rules for splitting up assets in a divorce depend on whether they’re considered separate or marital property. For instance, if you already have money in a 401k and get married, it would be considered separate property that you don’t have to divide.
However, in some states, any increase in the value of separate property during a marriage, could also be considered marital property. Yes, it’s confusing.
All income and assets acquired by either spouse during a marriage are usually considered marital property, no matter who’s name is on a piece of property or an account. Whether a split is 50/50 or some other percentage depends on the state where you live and many other factors, so be sure to consult a divorce attorney.
Let’s assume that your retirement assets were built during your marriage and could be divided in a divorce. The process to split up your retirement funds depends on the type of account, such as whether it's a workplace plan or an IRA.
All income and assets acquired by either spouse during a marriage are usually considered marital property, no matter who’s name is on a piece of property or an account.
What is a Qualified Domestic Relations Order (QDRO)?
Workplace plans, including your 401k, 403b, or pension, are covered by a federal law called the Employee Retirement Income Security Act (ERISA).
If your divorce settlement says that you’re obligated to split up a workplace retirement plan, a court must order a legal document called a qualified domestic relations order or QDRO. It tells your retirement plan administrator how much to pay out to the receiving spouse.
Typically, amounts you take out of a retirement account before reaching the official retirement age of 59½ are subject to income tax, plus a 10% early withdrawal penalty.
However, having a QDRO allows funds to be withdrawn without penalty, as long as they’re rolled over into another retirement account, such as an IRA. But if the receiving spouse cashes out the funds, he or she will be subject to income tax, but not an early withdrawal penalty.
What Is a Transfer Incident to a Divorce?
On the other hand, if you have individual retirement accounts, such as a traditional IRA, Roth IRA, or SEP-IRA, state law applies. In that case you don’t need a QDRO, but instead need a divorce decree that authorizes an action called a “transfer incident to a divorce.”
That language allows an IRA administrator or custodian to transfer all or a portion of the account to the receiving spouse. Just like with a workplace plan, if the new owner rolls over funds into a new or existing retirement account there’s no income tax or early withdrawal penalty due.
Once a receiving spouse receives retirement assets, he or she has sole responsibility for future tax consequences, not the original owner. After you send or receive retirement assets to an ex-spouse, make sure you update the beneficiaries listed on your account, plus any other financial assets and insurance policies you own.
Free Resource: Retirement Account Comparison Chart (PDF download) - get the rules for the most popular retirement accounts
Retirement Question #2:
April says, “My employer offers a 401k with matching contributions. However, I’m hesitant to participate because I’m not sure about the wealth management group that provides the plan. For instance, they have a lot of typos on their website and require a temporary username that is my social security number, which makes me uncomfortable.
I do have a Roth IRA that I contribute to regularly. Do you think I’m just being paranoid by not taking advantage of my employer’s plan?”
Answer: I would never encourage you to use services or make investments that your gut is telling you to stay away from. My advice is to have a consultation with your 401k representative from the wealth management group and voice your concerns.
If the 401k provider doesn’t have good answers to your questions or offer solutions that put you at ease, speak to your benefits administrator at work. Let him or her know the reasons why you’re backing away from the 401k and recommend that the company make a switch to a more reputable provider.
Employers offer retirement benefits to be competitive and to retain good employees. So if they know that you’re not happy with the retirement plan, they should be open to considering a change.
In the meantime, be sure to max out your Roth IRA every year. Your goal should be to save a minimum of 10% to 15% of your gross income for retirement.