How and When to Use QDROs
Written By: Cary B. Stamp CFP®, CDFA™
For many individuals, retirement benefits now exceed life insurance proceeds as the largest asset in a probatable estate. And as the largest asset in an estate, it’s reasonable to assume that retirement benefits can also make up a significant asset in a divorce. So with that in mind, the opportunity to use retirement benefits to fund a divorce becomes more practical.
However, removing money from a qualified retirement plan can have drawbacks …
The plan administrator is not required or permitted to assign a participant’s interest to another person. These “anti-assignment and alienation” rules are intended to ensure that a participant’s retirement benefits are actually available to provide financial support during the participant’s retirement years.
Therefore, the only way to access the money is for the plan participant to withdraw it. But then he or she will be responsible for the income tax on the amount withdrawn. Plus a 10% penalty will be charged if the participant isn’t at least 59½.
Another problem can arise if a non-cooperative employee moves assets and income to the retirement plan in order to delay paying alimony and other obligations.
Enter the QDRO
But under a limited exception to the anti-assignment and alienation rules, a Qualified Domestic Relations Order (QDRO) may assign some or all of a participant’s retirement benefits to a spouse, former spouse, child, or other dependent to satisfy family support or marital property obligations.
A QDRO is a court order used to divide retirement plan assets between a divorcing couple. It can also be used to collect child support or alimony from a plan participant’s retirement assets. It is signed by the Family Court Judge with jurisdiction over the divorce case, and filed with the Court.
ERISA requires that each retirement plan pay benefits in accordance with the applicable requirements of any “qualified domestic relations order” that has been submitted to the plan administrator. The plan administrator determines whether a domestic relations order is a QDRO.
Once approved by the plan administrator, the assets are divided per the terms of the QDRO, and a separate account is established for the non-participant spouse.
The types of retirement plans covered, include:
- Defined benefit pension plans
- Defined contribution and 401(k) plans
- 457 deferred compensation plans
- Federal and military pension plans
- State-sponsored retirement
The recipients are responsible for the income taxes on the proceeds, payable at their ordinary tax rate. However, the tax can be avoided if the money is rolled over into an IRA or other qualified retirement plan. That would allow the funds to grow tax-free until withdrawn. And if the payees have the transfer made directly to their IRA trustee, they’ll avoid the 20% federal income tax withholding.
The good news for plan participants under the age of 59½ is that by using a QDRO they’ll avoid the IRS’ 10% penalty normally charged for early withdraws.
When Might You Consider Using a QDRO?
Suppose for example, that both parties agree to equally divide a wife’s 401(k) plan. Without a QDRO, she’ll be responsible for the tax due, plus the 10% early withdrawal penalty if applicable. As a result, her husband gets a tax-free windfall.
Another example would be if husband and wife agree to split all assets 50/50. The husband, though, wants to keep his entire collection of valuable coins, but doesn’t have the cash to compensate his wife. A QDRO could be used to give her a greater portion of his retirement plan.
A QDRO could also be especially valuable if a participant has not retired …
Federal law generally requires that defined benefit plans and certain defined contribution plans pay retirement benefits to participants who were married on the participant’s “annuity starting date” (this is the first day of the first period for which an amount is payable to the participant) as a “qualified joint and survivor annuity” (QJSA).
When benefits are paid as a QJSA, the participant receives a periodic payment (usually monthly) during his or her life. And the surviving spouse of the participant receives a periodic payment for the rest of the surviving spouse’s life upon the participant’s death.
Federal law also generally requires that, if a married participant with a non-forfeitable benefit under one of these types of plans dies before his or her “annuity starting date,” the plan must pay the surviving spouse of the participant a monthly survivor benefit. This benefit is called a “qualified preretirement survivor annuity” (QPSA).
Those defined contribution plans that are not required to pay retirement benefits to married participants in the form of a QJSA or QPSA (like most 401(k) plans) are required by Federal law to pay any balance remaining in the participant’s account to the participant’s surviving spouse after the participant dies.
Now here’s the potential problem …
If a participant and his or her spouse become divorced before the participant’s annuity starting date, the divorced spouse loses all rights to the survivor benefit protections that Federal law requires be provided to a participant’s spouse!
And if the divorced participant remarries, the participant’s new spouse may acquire a right to the Federally mandated survivor benefits. So the ex is left with nothing!
A QDRO, however, can remove that problem.
To the extent that a QDRO requires that a former spouse be treated as the participant’s surviving spouse for all or any part of the survivor benefits payable after the death of the participant, any subsequent spouse of the participant cannot be treated as the participant’s surviving spouse.
For example, if a QDRO awards all of the survivor benefit rights to a former spouse, and the participant remarries, the participant’s new spouse will not receive any survivor benefit upon the participant’s death.
If such a QDRO requires that a defined benefit plan, or a defined contribution plan subject to the QJSA and QPSA requirements, treat a former spouse of a participant as the participant’s surviving spouse, the plan must pay the participant’s benefit in the form of a QJSA or QPSA unless the former spouse who was named as surviving spouse in the QDRO consents to the participant’s election of a different form of payment.
It should also be noted that some retirement plans provide that a spouse of a participant will not be treated as married unless he or she has been married to the participant for at least a year. If the retirement plan to which the QDRO relates contains such a one-year marriage requirement, then the QDRO cannot treat the alternate payee as a surviving spouse if the marriage lasted for less than one year.