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Be aware of taxes when dividing up retirement accounts

Divorcing couples in North Carolina have to worry about a number of issues, including property division. In addition to physical property, such as the family home and vehicles, couples may also have to divide up their accounts.

When one or both spouses have been working for a long time, they likely have at least one retirement account. Many people have 401(k)s or profit-sharing retirement plans through their employer, while others are self-employed and have an individualized plan. As you and your spouse work out the property division details of your divorce settlement, you may have to divide these accounts (as long as they are deemed marital property). Before you agree to anything, it is important to remember that your taxes may be greatly affected.

Qualified domestic relations orders (QDROs) are required to divide qualified plans like 401(k)'s. The QDRO will give your spouse a percentage of your retirement account or dollar amount but the transfer will be tax-free since it is incident to the divorce. The QDRO will also specify that each spouse is responsible for the income tax owed on distributions from their share after the transfer occurs.

Different retirement plans have different rules for how the account can be divided. Most qualified plans will establish a separate account for the spouse receiving the funds in their own name. Some will let the spouse receiving the funds roll the amount over into an already existing account in their name or an IRA.

For retirement accounts not subject to ERISA, such as most government plans and IRA accounts, a Domestic Relations Order (DRO) may be necessary for the transfer. Like a QDRO, the DRO ensures that the transfer is tax-free as an incident of the divorce. A DRO can usually only be entered at the time of or after the divorce, whereas a QDRO may be able to be entered prior to the actual divorce judgment.

The tax-related consequences of moving money out of these accounts without the proper documents in place can be considerable, which is why it can be crucial to talk to your attorney before doing anything with your financial accounts during a divorce. If you try to do the transfer on your own without the proper documents, you may be hit with tax penalties as well as income tax on the distribution.

Many people do not think about future taxes as they split up their retirement accounts during the divorce, and this can be a costly oversight. By putting a QDRO or DRO in your agreement, both you and your spouse will be well-protected come tax season. As a newly single person, it is more important than ever to take care of yourself financially and ensure post-divorce stability.

Source: MarketWatch, "Getting Divorced? How to avoid tax pitfalls when splitting up retirement accounts," Bill Bischoff, Aug. 1, 2017

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