Dividing assets after a divorce may include dividing the proceeds of a retirement plan. Separating the proceeds of a retirement plan is more difficult than distributing other assets. They can have significant tax consequences when drawn down upon earlier than expected. The instructions for distribution and the terms of any division must be communicated to the plan administrator.
Ensuring that retirement benefits are properly divided requires a Qualified Domestic Relations Order, commonly referred to as a QDRO. Below, we’ll explain what it is and how to use it to divide your assets.
What Is A QDRO?
A QDRO is a document included in a divorce decree or settlement agreement. It establishes the legal right of one spouse to receive at least some of the other spouse’s share of benefits under a qualified retirement plan.
The order designates the other spouse as an alternate payee under the plan. It details how much of the qualified account is to be disbursed and in how many payments. It may take the form of an agreement to split payments between the original and alternate payee or an order to disburse a fixed sum to the alternate payee at one time.
QDROs exist for two primary reasons. First, it establishes a binding legal document upon which the plan administrator can adjust payments or disburse funds. Without such an order, the plan administrator would be caught between two parties with differing objectives.
Second, the order allows the original payee to avoid facing a tax liability on the withdrawal. Without the order, the original payee would be required to pay taxes on the withdrawal despite the fact that the proceeds from it went to the alternate payee.
With a valid order, the tax liability for the withdrawals will then shift to the alternate payee. However, the alternate payee may avoid tax liability if the proceeds from the qualified retirement plan are rolled over into another qualified plan, such as an Individual Retirement Account. If money is not rolled over but is instead used to pay living expenses, the alternate payee may incur early withdrawal penalties.
Creating A QDRO
Both spouses in a divorce should seek legal counsel before attempting to draft a QDRO on their own. Like any legal agreement, it may be called into question later. Seemingly minor drafting errors and changes in terminology can completely change the meaning of the document. The Internal Revenue Service (IRS) often disregards improperly drafted QDROs. The agency often assigns tax liability to spouses who receive no income from their former spouses withdrawing funds from their retirement accounts.
If possible, the order should be drafted in its entirety by legal counsel. Then, each party should have his or her attorney review the document before signing it.
Having said that, the parties may draft and create a QDRO if they follow all of the necessary steps and avoid common pitfalls. The order must contain each party’s name, mailing address, and social security number. It must also include the plan name and number as well as the terms of the distribution to the alternate payee. This can include fixed amounts or payments over a set period. Omitting any of this information, even if both parties and the plan administrator fully understand the terms of the order, can lead to issues with the IRS later.
In addition to drafting the document, the alternate payee should seek the advice of either an attorney or a tax accountant. Both professionals can provide guidance on how to transfer the funds pursuant to the couple’s drafted order.
Again, doing anything with the funds other than rolling them over into a qualified retirement plan, even temporarily, may lead to a tax liability on the part of the alternate payee. Partial rollovers may also result in tax liability. This tax liability will usually consist of a 10 percent early withdrawal penalty in addition to standard state and federal income tax liabilities.
Limitations On QDROs
There are a few limits to QDROs. Foremost among these issues is that they only apply to “qualified” plans. Qualified plans include those that are eligible to receive special tax treatment under the law, such as 401(k) and 403(b) plans. Not every plan is eligible for this treatment or classified as “qualified.”
Anyone with questions about whether their particular arrangements require a QDRO should discuss the issue with legal counsel. Additionally, the orders cannot compel the plan administrator to provide benefits that would exceed the scope of the plan or provide funds in excess of the balance available therein.