Divorce negotiations can be long and arduous, but it’s important not to lose focus when discussing an annuity. You need to understand exactly what will happen to your annuity contract, especially since splitting an annuity can increase your tax liability depending on how you do it. Whether the annuity is in the accumulation or distribution phase can also dictate your options. In this article, we’ll cover how annuities are sometimes treated during a divorce, the most common ways to divide an annuity, and how to make the most of the split.

Are Annuities Protected in a Divorce?

An annuity may be protected in a divorce only if it is considered separate property. If the annuity is marital property, it must be split equitably in the divorce.  

Marital property is all property a married couple acquires during their marriage. This includes cash, bank accounts, securities, retirement accounts, and annuities. Whether or not an annuity is considered marital property depends on who purchased it and when.

Note: State laws regarding separation and divorce vary. If you have questions regarding how these might be resolved in your state, you should consult an experienced matrimonial lawyer. This article is intended for general information purposes only and is not necessarily applicable to any specific situation. It is not legal advice.

Are All Annuities Marital Property?

If a spouse completely funded an annuity before marriage, the annuity often isn’t considered marital property. However, if a spouse purchased a deferred annuity before marriage and continued to pay premiums during the marriage, that annuity could be considered marital property.

Any annuities that were purchased during the marriage are also marital property. This is the case even if the annuity contract doesn’t list the other spouse as an owner, annuitant, or beneficiary.

However, an annuity may be considered separate property if the owner purchased it solely with inherited funds or received the annuity as a gift, even if this took place during the marriage.

How To Divide an Annuity in a Divorce

There are a few main ways annuities can be divided during divorce proceedings:

• Withdraw funds early: One option is for the divorcing couple to withdraw the value of a deferred annuity that hasn’t begun payments as a lump sum. The withdrawal may be subject to surrender charges and is taxed as regular income for both parties. Withdrawals before age 59 ½ can also be subject to an early withdrawal tax.
• Split the annuity into two new contracts before annuitization: Another common way to divide an annuity is to cash out the account, split its value, and purchase two new annuity contracts. These can be immediate annuities that begin paying within a year or deferred annuities that start paying after an accumulation period. Splitting an annuity in the first several years before annuitization often requires a surrender charge. However, some insurers may waive this charge if you replace the existing annuity with annuities issued by the same insurer.
• Transfer to retirement accounts: Divorcing couples can also split the annuity’s value and transfer funds directly to retirement accounts. This avoids IRS withdrawal penalties but not surrender charges from the annuity provider.
• After annuitization: Once an annuity contract has been annuitized, a judge may order splitting the payments with one spouse as the payee, and in some cases, the insurance company will allow two payees to receive their portion of the annuitization as long as the annuitant is not changed.

There are many types of annuities, each with multiple contract options. The best way to split an annuity in a divorce depends on your unique situation. That’s why it’s a good idea to work with a financial advisor or annuity expert in conjunction with a divorce lawyer.

What If the Annuity Is Already Paying Out?

Generally speaking, payment terms for deferred annuities can't be changed once the annuity enters the payout phase via annuitization. For immediate annuities, payment terms are set upon purchase.

If the owner has designated their spouse as a contingent annuitant and payee, the spouse will receive payments upon the annuity purchaser’s death. This is true even if the couple gets divorced during the payout phase.

Note: All guarantees are subject to the claims-paying ability of the insurer.

Can an Annuity Be Transferred in a Divorce?

Deciding what to do with an annuity may be just one part of a larger negotiation about dividing assets in a divorce. Instead of dividing the annuity, the purchasing spouse may be able to maintain ownership or transfer ownership to the other spouse. The spouse receiving the annuity may agree to give up an asset of equal value in exchange.

In this case, you have to work with the insurance company that provided the annuity to transfer ownership. When done correctly, the new owner can take over the annuity without triggering a tax event.

If one spouse transfers an annuity to another within a year of the divorce, the transfer is tax-exempt under Internal Revenue Code Section 1041. That means the recipient doesn’t pay income tax for gaining ownership of an annuity that year. They would, however, be responsible for taxes for any income payments from that annuity that year.

How Splitting an Annuity Impacts Its Value and Growth

Annuities are complex. How and when you split them can change their value and growth potential over time. 

Let’s say a couple purchases a deferred annuity with a 10-year guarantee period but gets divorced five years later. They'll likely pay surrender charges to divide the current value of that annuity into two. Because some value is lost to annuity surrender fees, there will be less value to continue growing the two subsequent annuity contracts.

Splitting the annuity also means each spouse has less money to purchase a new annuity with. For instance, one spouse may want an immediate annuity instead of a deferred annuity. Considering an even split and surrender charges, they’ll have less than half the original annuity’s value to use for the premium. Therefore, the new annuity wil likely pay out much less than the original annuity.

Even if a spouse takes their “half” and purchases a deferred annuity with similar terms to the old annuity, the annuitized value will be lower because you’re starting with less money in the account value during the deferral period.

The Role of QDROs in Divorced Spouse Annuities

A qualified domestic relations order (QDRO) is a court order that specifies how to divide retirement plan assets in a divorce. Splitting an annuity during divorce may require a QDRO depending on how the plan was purchased.

Qualified annuities are purchased with pre-tax funds within a qualified retirement plan, such as a 401(k), 403(b), or pension. A QDRO is required if the qualified plan being split is covered by the Employee Retirement Income Security Act (ERISA). The QDRO document changes who is entitled to the retirement plan and allows the tax-deferred status to continue if the recipient rolls the value into their retirement account.

A QDRO is not required if the qualified annuity is part of an IRA, which is not governed by ERISA regulations. QDROs are also not required for nonqualified annuities, which aren’t considered retirement plan assets. A couple going through a divorce can simply work with the annuity provider,  the divorce lawyers, the judge, or the mediator to decide how to divide these annuities. However, a QDRO may be useful to help spouses avoid paying the 10% tax penalty for early withdrawals before age 59 1/2. Distributions from a QDRO are not subject to the 10% early withdrawal penalty.

Taxes and Penalties To Consider

If you aren't careful, dividing an annuity during a divorce can trigger a taxable event. To avoid this, the divorcing couple generally must directly transfer funds from the first annuity into new annuities or retirement accounts. 

As we’ve mentioned already, a QDRO is required to maintain tax-deferred status if the annuity is part of a qualified, employer-sponsored retirement plan. Without one, any distribution either spouse receives would be taxable as income. A lump sum distribution can significantly raise the recipient’s taxable income that year, too. Distributions from nonqualified accounts are also taxed, though a portion of the distribution is considered a return of the original premium and not taxed.

Note: Any reference to the taxation of annuities in this material is based on Annuity.com’s understanding of current tax laws. We do not provide tax or legal advice. Please consult a qualified tax professional regarding your personal situation.

Handle an Annuity Carefully During a Divorce

Dividing an annuity in a divorce requires careful consideration. You may fail to maximize the value of an annuity split or realize the tax implications without proper guidance. Divorce lawyers help work through the big picture but they might not know the financial repercussions of splitting an annuity in your situation. Similarly, financial planners or tax experts may be able to help you navigate the tax implications of your annuity. But even they may not know the best way to maximize the value of your account after divorce.

To ensure you’re making the best decision for your annuity, it’s best to work with an annuity expert who knows the ins and outs of annuity contracts.