Annuities & Divorce Laws
Equitable distribution can be a complicated and costly process in divorce proceedings. Though difficult, splitting annuity assets, properties and other investments is an inevitable part of the process.
Dividing Annuity Assets in Divorce
Dividing community property, or property jointly owned by a married couple, can often be a complicated process, with your financial options dictated by potential tax implications. You should seek to understand the long-term consequences of changing your annuity policy as you plan for your new life.
An estimated 40 to 50 percent of couples in the United States divorce, according to the American Psychological Association. As a result, a large number of couples have to divide assets, including retirement funds and houses.
While some things may be easy to divide equally, others are not. Some belongings are sentimental, while others — such as annuities — involve complicated financial calculations. Some divorce attorneys recognize the difficulty of this division process, specifically for the tax implications and the process of altering the initial annuity policy.
- Individuals can choose to withdraw a portion or all of an annuity and directly distribute it to both parties. Keep in mind, however, that a large withdrawal from an annuity may reduce benefits, including death benefits.
- Divorced couples can choose to have awarded amounts transferred directly to them through an IRA account.
- Start a New Contract
- One of the most common ways to divide an annuity is to withdraw from an existing contract and create two new contracts for both parties, with new benefits and contract values.
- Transfer Ownership
- Transferring ownership does not split an annuity between two parties. Instead, it grants all rights and control of an existing annuity to one party in order for a new annuity contract to take effect.
Types of Divorce Settlement
There’s more than one way to get divorced, and both sides have their say. Even so, state laws and the amount of investment assets involved dictate some of the options.
- Uncontested Divorce
- An uncontested divorce involves mutually agreed upon terms and cooperative behavior. There is not a formal trial or lawyer, and often no court appearance is required.
- Default Divorce
- A default divorce can be granted by the court when one spouse is not participating.
- Fault & No-Fault Divorce
- Fault and no-fault divorces involve irreconcilable differences, whether one spouse is to blame or if neither spouse is found at fault.
- Mediated Divorce
- Within a mediated divorce, a couple agrees to engage a neutral third party to mediate disputes and division of assets.
- Collaborative Divorce
- In a collaborative divorce, lawyers on both sides work with clients and each other to reach settlement.
- Arbitration is an alternative to a court trial whereby the couple hires an arbitrator, typically a lawyer or judge, to make decisions. Arbitration is a private proceeding, and the arbitrator's decision is binding in most cases.
- Contested Divorce
- A contested divorce requires a judge to decide terms, which often involve custody and child support, property division, debt allocation, alimony and temporary spousal support.
- Summary Divorce
- Summary divorce involves shorter marriages, fewer assets, less debt and no children. They do not require lawyers.
What Is a Gray Divorce?
Getting divorced later in life presents a unique set of problems. One out of 20 divorcing Americans is 65 or older and considered part of what is termed a “gray divorce.”
In a gray divorce, since children are usually grown, dividing assets is usually the focus.
- Carefully analyze all your retirement accounts. Retirement savings, including the cash value of annuities, are almost always split evenly — even if one spouse is considered at fault for the divorce.
- Ask your attorney about having your spouse provide health care coverage as part of the settlement, if necessary. Getting health insurance in your 60s can be particularly challenging, and Medicare doesn’t kick in until age 65.
- Review your rights under Social Security before the divorce is final. If you’ve been married for more than 10 years and you’re above the age of 62, you can collect Social Security in the name of your former spouse without reducing his or her benefits.
- Discuss tax concerns with your accountant. Filing as single means paying more in taxes.
Annuities as Marital Property: Divorce Settlement Laws
The division of an annuity that is considered marital property must meet state law and insurers’ rules about divorce. The passage of time affects the value of payments.
A court may not consider certain annuities as marital property if they were purchased prior to the marriage and if no one made premium payments after. When annuities remain with their original owner, splitting them is unnecessary. However, if both parties paid annuity premiums while married, the annuity is typically split. Some annuities are owned jointly between spouses, while others are individually owned. You can transfer in part or in entirety an individually owned annuity. However, transferring a large portion of annuity assets can be considered an excess withdrawal and may reduce the amount of death benefits.
During a divorce, a couple may be able to change some or all of contract terms. The issuing company dictates what can be changed and usually requires notification from both spouses or papers from the divorce decree. Some contracts have more restrictive language than others about what can be changed or divided. Annuity regulations can be found in the original investment contract.
- The current annuity owner(s) — the person(s) who made premium payments
- The person(s) receiving payments — the current annuity owner and/or spouse
- The beneficiaries designated to receive remaining payments or death benefits
Transferring an Annuity: What You Need to Know
Couples should consult a financial advisor early in the process to avoid problems that commonly arise when transferring annuities in divorce. The advisor will determine the best way to proceed, keeping in mind the type of annuity involved.
It’s important to get information from the annuity carrier about how it handles dividing contracts in divorces. You may have to talk to someone in the legal department to get the correct details. Ask the company to put the information in writing before you have a court order so you can use it to seek changes in the order, if necessary, before it is final.
There are several options for dividing an annuity: You can withdraw all or part of it; you can have it transferred into an IRA; you can withdraw from the original contract and have new contracts issued to you and your divorcing spouse. The last option is generally preferred by insurance companies because it’s easier for them to process.
Consider having one spouse keep an entire annuity and allowing the other to have something else of value. This can make things less complicated and avoid possible disadvantages from dividing the contract.
Tax Consequences of Annuity Ownership Changes
A divorcing couple with a jointly owned annuity may be required to split their investments, along with all remaining assets, property tax basis and funds. Maintaining a joint annuity contract can bring on negative tax consequences for both parties. Often, one spouse transfers the annuity, in whole or part, to the other spouse, granting full ownership of the contract. This transfer includes all tax implications.
The IRS allows certain exemptions for owner transfers related to divorce. Done correctly, the transfer should not be subject to tax consequences and contract fees. Couples transferring ownership of the annuity from one spouse to another don’t face added tax liability for the transfer. In other words, the IRS treats divorce as a non-taxable event. The annuity maintains its tax-deferred status, though the new annuity owner will still owe income taxes on distributions. If transferred incorrectly, any transferred assets can immediately be taxed as ordinary income and may trigger additional tax penalties and surrender charges.
If one spouse accepts an early distribution from an annuity as part of a divorce settlement, the IRS will charge income taxes on earnings in addition to an early withdrawal penalty. If the policy owner moves the asset to a new annuity, a process known as a 1035 exchange, they will not owe added taxes. For the 1035 exemption to apply, the transfer must meet certain stipulations.
- Transferring or splitting an annuity may initiate a new surrender period, meaning the time table for higher interest on withdrawals is reset as defined by the insurance company.
- Individual annuity contracts put limits on what transfers in the case of a divorce. Most contracts do not allow transfers of living benefits or added riders.
A couple with an annuity held in a qualified retirement plan — including a 401(k) or an IRA account — needs a Qualified Domestic Relations Order (QDRO) to protect tax exemption. A court issues the order and often divides retirement assets. However, if the annuity is nonqualified and taxes have already been paid on the money invested in the account, a QDRO is not required to split the annuity. Only the earnings are taxed upon withdrawal.
Taking the original contract terms into consideration, the court may allow a couple to divide future periodic payments or distribute the annuity in a lump sum. The QDRO needs to be in place prior to the finalized divorce in order to protect both parties.
The court requires insurers to comply with orders for splitting the annuity. A state court judgment, decree or approval of the property settlement agreement can define rules for dividing the asset.
Federal Employee Retirement Benefits
Federal employee retirement benefits, such as the civil service retirement annuity, are governed by the Civil Service Retirement System and Federal Employees Retirement System and are not subject to the Employee Retirement Income Security Act (ERISA). Because ERISA governs private-sector pensions, QDROs for dividing these assets in a divorce won’t necessarily be accepted for federal employees.
According to the U.S. Office of Personnel Management, the benefits available under ERISA plans are different from those under CSRS and FERS plans. In its handbook for attorneys, OPM states that, for example, “the most important difference between ERISA plans and CSRS and FERS is that under ERISA the former spouse’s share of the benefit can begin when the employee reaches the minimum retirement age, even if the employee is still working.”
This benefit does not exist under CSRS and FERS plans, and so, unless a QDRO states explicitly that the order complies with OPM’s regulations, it will not be accepted.
Full details regarding the division of a federal employee’s annuity or pension can be found in Title 5 of the United States Code and Title 5 of the Code of Federal Regulations.
Surrendering or Selling Payments
To resolve annuity disputes caused by divorce, couples can surrender or sell annuity payments for cash. Annuity owners can surrender their policy through the issuing company. However, they may owe surrender fees depending on how long the policy has been in place, whether distributions have started and the amount of disbursed payments.
Although you lose a portion of the asset’s value when selling or surrendering, dividing a simple cash total can be easier than having an actuary determine value, trying to split the policy or changing your contract.
6 Cited Research Articles
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- American Psychological Association. (n.d.). Marriage & divorce. Retrieved from https://www.apa.org/topics/divorce/
- Vasilef, L. (2016, August 2). Understanding the Trickiness of Dividing Annuities in Divorce. Retrieved from https://www.iris.xyz/solutions/divorce/understanding-the-trickiness-of-dividing-annuities-in-divorce/
- Cussen, M.M. (2016, May 23). Divorce and Annuities: What Clients Need to Know. Retrieved from https://www.investopedia.com/articles/personal-finance/093015/divorce-planning-checklist-what-you-need-know.asp
- Mercado, D. (2012, March 18). Breaking up is hard to do – especially with annuities. Retrieved from https://www.investmentnews.com/breaking-up-is-hard-to-do-especially-with-annuities-43000
- Office of the Law Revision Counsel. (n.d.). Title 5—Government Organization and Employees. https://uscode.house.gov/view.xhtml?path=/prelim@title5&edition=prelim
- U.S. Office of Personnel Management. (1997, July). A Handbook for Attorneys on Court-ordered Retirement, Health Benefits and Life Insurance Under the Civil Service Retirement Benefits Federal Employees Retirement Benefits Federal Employees Health Benefits Federal Employees Group Life Insurance Program. https://www.opm.gov/retirement-services/publications-forms/pamphlets/ri38-116.pdf