Why is it important to know the difference between Roth and Traditional retirement accounts when divorcing?
We all know that planning for retirement is important, given that most workers no longer have access to pensions. Social Security will likely need to be adjusted in some way in order to sustain current and future workers. When deciding how to divide property, it’s necessary to know what types of retirement accounts are in the household.
Most workers have access to “defined contribution” plans such as IRAs and 401(k)s, where the amount that is invested is defined by the employee, so the amount at retirement will vary. (In the past, companies paid out a “defined benefit” or pension where the retirement payment amount was defined by a formula.)
Currently, different types of retirement plans generally have similar rules, though the annual amount allowed to be contributed may differ. You must have earned income, which includes salary/wages and alimony, in order to contribute.
There generally are penalties to withdraw early, usually before age 59 ½, though there are some exceptions to this. Retirement accounts grow tax-deferred, which means there are no taxes to pay while the money is accumulating. Only distributions from the account are potentially subject to tax. Whether or not income taxes must be paid on withdrawals, and whether withdrawals must start at the age of 70 ½, usually depends on whether pre-tax or after-tax money was used to fund the plan.
Pre-tax (Traditional accounts)
If either the contribution is deducted on your tax return, or it’s withheld from your paycheck before taxes are calculated, then the account is Traditional. Since taxes on this money have not been paid, ordinary income tax is owed on the full amount of the withdrawal.
By contrast, capital gains taxes (which are often lower) are levied only on the profit for a “regular” or non-retirement investment account.
The IRS requires that withdrawals begin at age 70 ½, which allows them to capture some tax revenue from the account. This required minimum distribution or RMD is calculated by a formula, and the first year for most people is about 4% of the account balance as of 12/31 of the previous calendar year.
When contributions are either not deducted on the tax return or taken from the paycheck after taxes have been computed, the money can be withdrawn tax- and penalty-free — as long as the account has been open five years and the account owner is at least age 59 ½.
These are known as Roth accounts, and for a Roth IRA, there is no age 70 ½ withdrawal requirement since taxes have already been paid. In some cases RMDs are required on a Roth 401(k). Note that employer contributions are pre-tax, so even if the worker is contributing to a Roth 401(k), any match they receive will be in a Traditional account.
When dividing property, therefore, it’s important to note the different tax situations. If the household has both a Roth and a Traditional account, both accounts should normally be divided between the spouses. Otherwise, if one spouse takes the Roth they have a tax-free asset (assuming the age and holding period requirements are met), and the other spouse with the Traditional account has a taxable asset. This is not an equitable division.
Transfers and rollovers
Accounts should always be transferred like to like, so a Traditional is transferred (or “rolled over”) to another Traditional, and a Roth to a Roth. Transferring a Roth to a Traditional would be transferring a tax-free asset to a tax-deferred one.
Transferring a Traditional to a Roth will incur ordinary income tax on the entire amount rolled over because it’s a transfer from a tax-deferred account to a tax-free one. A traditional 401(k) can be rolled over to a Traditional IRA or a current Traditional 401(k) if the plan accepts it, and similarly with Roth 401(k) to Roth account transfers. As long as the like-to-like rollover is from one institution to another (and not to the owner’s bank account) there is no taxable event.
Using a QDRO for employer-sponsored plans
In general, withdrawals before age 59 ½ are subject to a 10% penalty, and if the account is Traditional, taxes are due on the amount withdrawn (not rolled over). However, if the withdrawal is made from a Traditional 401(k) pursuant to a Qualified Domestic Relations Order (QDRO), the 10% penalty is waived. Income tax is still due, so the plan will withhold 20% for taxes as mandatory.
For example, if you are under 59 ½ and receive $100,000 from your ex-spouse’s Traditional 401(k) as specified in the QDRO and you want to pay off bills, you could elect to take the entire amount as a distribution, and you would receive $80,000, with $20,000 withheld for taxes. If you only needed half the amount for bills, you could elect to take $50,000 as a distribution and roll over the remaining $50,000 into your Traditional IRA. You would receive $40,000, with 20% of the $50,000 distribution withheld for taxes, and $50,000 would be rolled into your IRA.
This penalty waiver for those under 59 ½ is only for employer retirement plan distributions, not for IRAs. In addition to knowing what the “tax flavor” of the retirement account is, you also need to know whether it’s an employer plan or an IRA, so that you know what options you have regarding these accounts.
When dividing property, it’s important to know whether the retirement accounts have been funded with pre-tax or after-tax money, because this has a significant effect on the taxation of withdrawals from these accounts.
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Originally published on www.divorcenest.com.