Dividing an annuity in a divorce: ownership, tax and paperwork pitfalls

An annuity in a divorce is easy to list on a property worksheet and surprisingly hard to divide. The balance printed on the statement is not what either spouse can spend, the insurance company does not take orders from a settlement agreement until its own forms arrive, and the cheapest-looking way to hand someone cash is usually the most expensive one. Most of the damage comes from a short list of mistakes, and nearly all of them can be avoided by asking the right questions before the decree is signed.

This post walks through those mistakes one at a time: how each happens, what it costs and how to avoid it. It is general information, not legal or tax advice. A divorce attorney and a tax professional who have seen the actual contract and decree are the right people for specifics, and the insurer's own forms decide what can physically be done.

How courts and settlements treat an annuity

Whether an annuity is divided at all depends on whether it counts as marital property. States differ. Some follow community property rules, under which most assets acquired during the marriage belong equally to both spouses, and others use equitable distribution, under which a court divides marital property fairly rather than necessarily equally. In both systems, an annuity bought with money earned during the marriage is usually marital, while one bought before the marriage, or with an inheritance kept separate, may be separate property. A contract bought before the wedding that kept growing during it can be partly one and partly the other, which is where lawyers earn their fees.

Once an annuity is marital property, the decree or the settlement agreement can do one of several things:

• Award the whole contract to one spouse, who keeps it and gives up something else of equal value.
• Divide the contract itself, with each spouse ending up as the owner of a share.
• Order a payment to one spouse that the other satisfies by taking money out of the contract.
• Treat the contract as one asset among many and offset it against a house, a retirement account or support.

The first option is often the cleanest, and the second and third are where paperwork and tax problems appear. The rest of this post assumes you are in one of those situations. If you want the background on how the contract itself is taxed, the guide on how annuities are taxed covers it, and life insurance and divorce covers the parallel questions for life insurance policies.

Mistake 1: treating the balance as spendable money

How it happens. The statement says $200,000. A brokerage account also says $200,000. The spreadsheet lists both at face value and each spouse takes one. It looks even.

What it costs. Inside a non-qualified annuity, bought with money that was already taxed, only the earnings are taxable when withdrawn, and they are taxed as ordinary income. The amount you put in, your cost basis, comes back tax-free. A brokerage account holding stocks has its own embedded tax, but it is usually taxed at capital gains rates. Two accounts with the same balance can therefore be worth different amounts after tax.

Here is a hypothetical. The annuity is worth $200,000 and the couple paid in $120,000, so $80,000 is deferred gain. The brokerage account is worth $200,000 and its basis is $200,000, so it carries no gain at all. Assume, purely for illustration, that the spouse who ends up with the annuity will eventually pay 24 percent tax on withdrawn gain.

• Deferred tax in the annuity: $80,000 × 24% = $19,200.
• After-tax value of the annuity: $200,000 − $19,200 = $180,800.
• After-tax value of the brokerage account in this simple case: $200,000.

The spouse who took the annuity received about $19,200 less, even though both accounts show the same number. The 24 percent is invented to make the arithmetic visible; the real rate depends on each person's income when the money comes out, which may be years later. The point is not that the gap equals $19,200. It is that the gap is not zero, and a settlement should say how the embedded tax was weighed.

How to avoid it. Ask the insurer for the contract's cost basis and surrender value, not just the account value. Ask whoever is advising on the settlement to compare the assets after tax, or at least to say in writing that the parties agreed to ignore the difference. A neutral, specific number such as "basis $120,000" belongs in the worksheet next to the balance.

Mistake 2: cashing out to hand over the money

How it happens. One spouse is owed $50,000. The annuity is the easiest place to find it, so the owner withdraws $50,000 and writes a check.

What it costs. A withdrawal from a non-qualified deferred annuity comes out earnings first. For a more detailed look, see taxing a non-qualified annuity withdrawal: gains come out first. In the example above, the earnings are $80,000, so the entire $50,000 is taxable. There may also be a 10 percent additional federal tax on the taxable part if the owner is under age 59½, and a surrender charge on the part above the contract's free-withdrawal amount. Here is a hypothetical tally, assuming the contract allows a free withdrawal of 10 percent of the $200,000 value each year and charges 5 percent on the rest:

• Free amount: $200,000 × 10% = $20,000, so $30,000 of the $50,000 carries a charge.
• Surrender charge: $30,000 × 5% = $1,500.
• Income tax at an illustrative 24 percent on $50,000 of gain: $12,000.
• Additional 10 percent tax if the owner is under 59½: $5,000.
• Total cost: $1,500 + $12,000 + $5,000 = $18,500.

The recipient gets $50,000 and the owner loses $68,500 of the contract. That is a heavy price for the convenience of using a single account, and the cost falls entirely on the spouse who made the withdrawal unless the agreement says otherwise.

How to avoid it. If one spouse is entitled to a share of the annuity, it is usually cheaper to transfer ownership of a portion of the contract than to cash it out. A transfer between spouses, or one made because of a divorce, is generally not a taxable event under federal law (Internal Revenue Code section 1041). The person who receives the contract takes over the existing basis and the deferred gain, and pays tax later, when money actually comes out. Confirm with a tax professional that your transfer qualifies, because the rules about timing and about being tied to the divorce instrument matter.

Mistake 3: assuming the court order moves the contract

How it happens. The decree says the annuity goes to the wife, or half to each. Everyone relaxes. Nothing is sent to the insurance company.

What it costs. The insurer changes its records on its own forms, signed by the owner of record, not on a settlement agreement it never saw. If the decree is not delivered, the husband is still the owner on the company's books. He can surrender the contract, change the beneficiary or take a loan if the contract allows one, and the company will honor his instructions. Years may pass before anyone notices.

How to avoid it. Treat the insurer as a third party that must be asked in its own language.

1. Call the annuity company's service department and ask what it requires for a transfer of ownership because of a divorce. Most have a specific form.
2. Ask whether the company will divide one contract into two, issuing a new contract to the other spouse, or whether the only options are to transfer the whole contract or to withdraw money. Policies vary by company and product.
3. Ask what documents it needs: a certified copy of the decree, signatures from both spouses, a tax identification number for the new owner, and sometimes a signature guarantee.
4. Ask what happens to the surrender schedule, any market value adjustment and any rider when ownership changes. The answer should come in writing.
5. Send the forms before the divorce is final if the settlement allows, and keep proof of delivery.

A divorce decree can be perfect and still fail if the company's records are never updated. Check a statement a month or two later to confirm that the owner of record has changed.

Mistake 4: forgetting the annuitant and the beneficiary

How it happens. An annuity has up to three roles: owner, annuitant and beneficiary. The owner controls the contract. The annuitant is the person whose life is used to measure the contract, such as the age that determines when income can start and, in some contracts, whether a death benefit is triggered. The beneficiary collects at death. The new owner gets ownership; the annuitant and the beneficiary stay as they were.

What it costs. Say a husband transfers the contract to his former wife but remains the annuitant, and the contract pays a death benefit when the annuitant dies. His death could now trigger a payout the new owner did not plan for, or end the owner's rights sooner than expected, depending on how the contract is written. Or the husband's own estate may be named as beneficiary of a contract he no longer owns. And if the old beneficiary designation still names the ex-spouse, she may inherit a contract she no longer wants to leave to her ex.

Some states have a revocation-on-divorce statute that automatically cancels an ex-spouse's beneficiary status. These laws vary, may not cover every type of contract and can be overridden by the wording of a decree or by federal law for certain employer plans. The guide on divorce and your ex as beneficiary: revocation-on-divorce laws explains the problem. Do not rely on a statute to do a job that a signed form can do.

How to avoid it. After the ownership transfer, the new owner should name a new beneficiary immediately. Ask the insurer whether the annuitant can be changed, and whether the change is allowed in the contract. If the settlement requires one spouse to keep the other as a beneficiary, say so explicitly in the decree and say for how long, because it conflicts with the usual rule that an owner may change a beneficiary at any time. A longer discussion of the three roles is in owner, annuitant, beneficiary: how three roles change what happens at death.

Mistake 5: mixing up qualified and non-qualified contracts

How it happens. Both spouses call it "the annuity." One is held in an IRA or an employer plan, and the other was bought with after-tax money. The rules are different, but the settlement language is the same.

What it costs. A qualified annuity, held inside a retirement account, is generally fully taxable when money comes out, because there is usually no basis. A transfer from one spouse's IRA to the other's can be done without tax when it is made because of a divorce or separation instrument, and it must be a direct transfer, not a withdrawal followed by a deposit. A withdrawal first and a transfer afterward turns a free move into a taxable event and, before 59½, may add the 10 percent additional tax.

An annuity held inside an employer plan, such as a 401(k) or 403(b), is usually divided by a qualified domestic relations order, known as a QDRO, a court order the plan administrator approves under its own procedures. Money paid to the former spouse under a QDRO generally avoids the 10 percent additional tax, but the person receiving it pays ordinary income tax unless the amount is rolled into the recipient's own retirement account. These rules are technical, so have a professional read the actual order.

How to avoid it. Start by labeling each contract as qualified or non-qualified and writing it in the settlement. Ask the plan or the insurer which kind of order or form it accepts. For an employer plan, a QDRO usually has to be drafted, submitted to the plan administrator for review and approved before it works, a process that can take weeks or months. Do not withdraw funds first and sort out the tax later.

Mistake 6: ignoring riders, bonuses and the surrender clock

How it happens. Spouses compare balances and ignore the features that make one contract more valuable than another: an income rider with a guaranteed benefit base, a premium bonus that is recaptured if the contract is surrendered early, an unexpired surrender schedule.

What it costs. An income rider usually belongs to the contract and its terms may be tied to the age of the owner or a specific person. Changing the owner can change what the rider pays, end a joint-life feature or void the rider outright, depending on the wording. A contract with a bonus may take back part of that bonus if it is surrendered during the schedule. Splitting a contract into two may restart a surrender schedule on the new part, may shrink a free-withdrawal allowance by half, and may leave each half below a minimum balance the company requires. These details are in the contract, not in the statement.

How to avoid it. Ask for a copy of the full contract, not only the annual statement. Look for the surrender schedule, the free-withdrawal terms, any market value adjustment, any rider and any language about ownership changes. annuity surrender charges and free withdrawals explains the parts of the schedule worth reading before anyone signs. If the contract has valuable guarantees, a split may destroy more value than a cash-out of another asset would. An offset, where one spouse keeps the whole annuity and the other takes something else, often preserves the features intact.

Mistake 7: trying to split a contract that is already paying income

How it happens. The annuity was turned into lifetime income years ago. The settlement says to divide the payments.

What it costs. An income stream that depends on the life of one person, and has no cash value, is hard to divide. The insurer calculated the payments for that person, and in many cases the contract bars assignment of future payments or does not recognize a court order that tries to redirect them. Whether a company will send part of each check to a former spouse depends on the contract and the company's rules. If it will not, the paying spouse may have to send money personally, which is a promise rather than a transfer, and the arrangement may fail if that spouse dies. For a period-certain option, the person named as beneficiary matters a great deal.

How to avoid it. Ask the insurer first whether it will divide payments under a court order and what the order must say. If it cannot, the settlement can value the stream (a calculation for an actuary or a financial professional, not a guess) and give the other spouse a different asset of matching value. If the stream is meant to support the other spouse after the paying spouse dies, a separate life insurance policy may be the tool, as covered in life insurance and divorce.

Mistake 8: leaving tax reporting to chance

How it happens. A transfer happens in one year, a withdrawal in another, and nobody tells the preparer who the owner is. Or the insurer reports a withdrawal under the old owner's Social Security number when the money went to the ex.

What it costs. The insurer reports taxable distributions on a Form 1099-R to the person who owns the contract when the money comes out. A misreported form creates notices and amended returns. A transfer that was meant to be tax-free but is later challenged as not connected to the divorce can create a tax bill for years of embedded gain.

How to avoid it. Keep copies of the decree, the transfer forms and the insurer's confirmation. Give both preparers the contract's basis and the transfer date. After the transfer, the new owner should ask the company to confirm the basis it has on record, because the old owner's records may include premium history that the new owner does not have.

Putting it in order: a short sequence

1. List every annuity, who owns it, who is the annuitant and who is the beneficiary, and whether it is qualified.
2. Ask each insurer for current value, surrender value, cost basis, the surrender schedule, any rider and its own divorce-transfer forms.
3. Compare the contracts after tax with the other assets, not only by balance.
4. Decide whether the contract stays whole with one spouse, splits, or is offset by another asset. Prefer a transfer to a cash-out unless a professional has run the numbers.
5. Write the settlement so that it names the contract, says what happens to owner, annuitant and beneficiary and sets a deadline for the paperwork.
6. Deliver the insurer's forms, confirm the change on a later statement and update the beneficiary.
7. Give the tax preparer the transfer documents and the basis.

For a settlement involving a large contract, both kinds of professional are worth consulting. A divorce attorney knows what the court can order and how the parties' state classifies the asset. A tax professional or fee-only planner knows how the numbers play out when the money is eventually withdrawn. Your state insurance department can also explain the rules that insurers in your state must follow, and it takes complaints if a company fails to process properly submitted forms.

Key takeaways

• A balance is not the same as spendable value. Compare an annuity with other assets after the tax embedded in its gain, using its cost basis.
• Cashing out an annuity to pay a spouse usually costs far more than transferring part of the contract, because withdrawals come out earnings first and can trigger surrender charges and an additional tax before 59½.
• The insurer acts on its own forms, not on the decree alone. Send the paperwork, then confirm on a later statement that the owner of record changed.
• Owner, annuitant and beneficiary are separate roles. Reset the beneficiary right away and ask what the annuitant change means for any death benefit.
• Qualified contracts follow different routes, such as direct IRA transfers and QDROs. Withdraw first and the tax and penalty problems start.