Ask the Boston Money Coach:
Divorce Financial Planning
Question from another financial planner: I have a client who has been divorced since October 2006. My client had a 401k leading up to the divorce and on 10/25/2006, when he filed for divorce, the 401k had $19,000 in it, and was 100% invested in a Fidelity MM fund. Now the value is closer to $20,000. His ex-wife is now asking for her share, and he’s pretty sure she’s entitled to half (it’s not in the divorce decree, but I believe that is standard).
Is there a “standard” for this situation for how to calculate the rate of return that “could have” been earned? And will the ex-spouse be able to make a claim based on this assumed rate?
If my client has cash on hand can he just give her the cash? It’s not some kind of “in-kind” transfer, is it?
Response by Money Coach Steve Stanganelli:
This is a classic case of why individuals need to consult with financial advisers BEFORE the divorce … but then again I’m biased here as a trained divorce financial planner in the Greater Boston area.
There should have been a Qualified Domestic Relations Order (QDRO) as part of the process and reviewed by the 401(k) administrator. Unfortunately, most divorce decrees tend to mention that one will be arranged, if at all, but never bother to have the QDRO reviewed prior to the decree. That’s important as there may be administrative policies in place that prohibit certain things noted in the proposed QDRO.
While the ex-spouse may be entitled to a portion, there is the possibility that she may not be entitled to half. While “half” is typically what is bounced around, it may not be correct in this case. It depends on a number of factors including the length of the marriage and when the 401(k) account was in place. For instance, if the 401(k) was set up and pre-dated the marriage, then it would be more proper to calculate the marital property portion based on the value at the time of the marriage through the date of divorce.
Another consideration is whether or not there was any other asset that was used as an “offset” when the decree was being negotiated. There may have been a separate calculation based on the total marital property. I’ve seen some folks waive the 401(k) portion in lieu of some other asset.
Get a QDRO Now
If that’s not the case, then she may be able to put a claim in for a portion. (But without a QDRO it’s like closing the barn door after the horse is gone.) If the parties are amenable, then they should have an attorney draft a QDRO and submit it to the 401(k) administrator for review. In some cases, the plan may be able to set up a separate account for the spouse who will then be able to choose investments appropriate for her age and risk profile. In other cases, it may be possible to withdraw the spousal portion.
If withdrawn then the decision needs to be made as to what to do with the funds. The funds can be used to fund another tax-deferred account like an IRA. If the funds are cashed out, then there will be tax consequences. And without a QDRO in place, it is conceivably possible for the spouse who is the 401(k) participant could be hit with the tax bill and penalties for an early withdrawal. This has happened to unsuspecting individuals.
Using An “Expected Rate of Return”
If you were thinking about using some sort of “expected return,” you can forget it. That approach is fraught with way too many assumptions and trying to determine what is the right number based on risk and the mix of investment choices available in the plan is going to be near impossible to get any sort of agreement between the spouses much less financial professionals or the courts.
Assuming some sort of 8% return on the money is going to be problematic at best for example with the ex-spouse and the plan administrator. You’ll just have to base it on the account value on the statement. (Though it would be better to use the amount of time married relative to the time the 401(k) plan has existed to determine the percentage to allocate to each spouse).
Using Cash Instead Not a Fair Trade
Suggesting to use the 401(k) participant spouse’s cash from a taxable account instead of using the funds from the tax-deferred account is simply unfair. This is like comparing apples to oranges. Paying the ex with cash now ignores the value of the tax-deferral of the 401(k) that the ex-spouse could at least continue to get in another IRA in her name. At the very least, the cash amount would need to be adjusted to make up for the lost benefit of tax deferral.
Ultimately, this kind of option starts the ex-spouse on a track where she will never quite be able to make up ground lost for her retirement needs.
