Retirement assets are an important issue in any divorce proceeding. After the marital home, retirement assets often represent the largest category of marital assets to be divided in a divorce settlement. These assets can include 401(k)s, 403(b)s, IRAs and pension benefits provided by an employer’s defined benefit plan. Divorcing spouses will often seek to divide these retirement assets as part of the overall separation.
The process of legally dividing certain retirement assets in accordance with a divorce settlement and without any income tax consequence is more complicated than it would be to simply divide a bank account, brokerage account, or even a contributory IRA account. One reason is the special income tax advantaged status of these retirement accounts. Another is the unique plan rules that company sponsored retirement plans commonly have to protect participants.
When dividing a 401(k) or pension, the plan participant (“member spouse”) legally relinquishes all or a portion of their account or benefit to the other spouse (“receiving spouse”). For the receiving spouse, it is imperative that they secure and protect their financial interest. This is accomplished with a Qualified Domestic Relations Order (QDRO) and the next sections of this article describe how it may be a critical divorce financial planning component.
Note that dividing an IRA or Roth IRA account during divorce that is not held through an employer plan does not require a QDRO. An IRA may be divided in divorce by the divorce decree and this process is commonly called an IRA “transfer incident to divorce.” If handled correctly, no tax is assessed on the IRA separation transaction and the movement of funds may be classified as either a transfer or a rollover by the IRA custodian. This is due to the simplified and less regulated structure of the IRA account. See this article on dividing IRA accounts during a divorce.
What is a Qualified Domestic Relations Order (QDRO)?
A Qualified Domestic Relations Order (QDRO) is a legal order that is used to divide assets in a retirement plan. This domestic relations order needs to be approved by a plan administrator on behalf of the state division of pensions and benefits as well as approved by a judge. Only after both approvals is the legal order considered “Qualified”. The purpose of the QDRO is to instruct and impose the withholding of a portion of a member spouse’s benefits for payment to a receiving spouse and document each spouse’s new designated benefit.
The order gives the receiving spouse financial protection and legally assigns the retirement benefits, which a marital settlement agreement alone cannot necessarily do. The order does this by permitting the plan administrator to legally divide the benefits allocated to each party without tax or other consequence. There is no way to divide qualified plan assets without a QDRO.
When is a Qualified Domestic Relations Order (QDRO) Necessary?
Generally, any employer-sponsored retirement plan that is governed by the Employee Retirement Income Security Act of 1974 (ERISA) will require a QDRO to divide the account or earned benefit. ERISA is a federal law that sets minimum standards for most voluntarily established retirement plans to provide protection for individuals in these plans. Every plan that is governed by ERISA is required to have a process for handling a QDRO filing, and the retirement plan must follow that exact process when dividing a retirement account in divorce. Once again, retirement plans not governed by ERISA, such as IRAs, do not require a QDRO to divide assets pursuant to divorce.
It is always recommended to check the specific plan administration guidelines before beginning the process. Every ERISA retirement plan is unique. Some ERISA plans may make dividing retirement assets in a divorce proceeding much easier than others.
How Does a QDRO Work to Divide Retirement Assets in Divorce?
Upon the filing and implementation of the approved QDRO with the plan administrator, the account/benefits get transferred to the receiving spouse’s name as if they were the original owner. The receiving spouse essentially steps in as the owner of the benefit upon completion of this process. Once they are assigned their retirement benefit, the receiving spouse has the option to rollover all or part of a qualified plan that they receive under a QDRO. It is the responsibility of the receiving spouse to ensure that the QDRO gets filed with the plan administrator to secure their financial interest and take necessary steps to move the assets.
A QDRO cannot accelerate the availability of funds. It is required to follow the U.S. tax code, ERISA regulations, and plan terms that specify the available time frame. For example, if a plan does not allow payments until age 55, a QDRO during a divorce will not change the availability to these funds. These will always be retirement benefits.
Furthermore, when the account/benefit is legally divided and transferred, there is no taxable event for either party. Once the receiving spouse withdraws funds or claims benefits, they are subject to ordinary income taxes as the original member spouse would have been.
What is Included in a QDRO Legal Order?
The QDRO is a legal document, pursuant to a divorce proceeding, that includes detailed information on the member spouse as well as the receiving spouse. It provides specific instructions to the plan administrator regarding the dollar amount and/or percentage of retirement benefit that is being re-allocated to the receiving spouse as well as the frequency of payments. The language in a QDRO is specific to each individually administered plan.
This means that if there is more than one 401(k) that originated from different employers, it would require a separate QDRO to be filed for each plan. Some retirement plans have standard QDRO forms and additional information to assist in the process. However, if the attorney specializes in QDROs, they can help to ensure that all the related issues in the marital settlement get incorporated into the QDRO so that the receiving spouse is fully protected. If not, they can assist in finding someone who does specialize in them. In a more complicated divorce proceeding, there are many nuances in dividing retirement plan assets that should be considered as part of the overall divorce plan. It is highly recommended you engage counsel.
Process & Timeline for Setting up a QDRO
A QDRO is not created overnight! There are several steps in the preparation of the QDRO, which contributes to the length of the process. Some steps in creating a QDRO during a divorce proceeding include the following:
- Review the retirement plan’s rules and procedures.
- Have the QDRO drafted by a professional (this can be an attorney or a company specializing in the preparation of QDROs).
- Obtain approval of the QDRO document from both parties.
- Submit a DRAFT QDRO to the plan administrator for approval to ensure that the language in the document adheres to the plan guidelines before submitting to the courts.
- Obtain both spouses’ signatures on the pre-approved QDRO document.
- Submit the signed order to a judge for approval in state divorce court.
- Send a certified copy of the approved QDRO to the plan administrator.
- Receive confirmation, acceptance, and implementation of the QDRO by plan administrator.
There is no guarantee of how long the entire process will take to receive an approved QDRO and divide the retirement plan assets. Given the number of individuals and offices involved in this process, it can take a few months and can often take longer than originally anticipated. Turnaround time could also fluctuate based on schedules and a backup of cases in the courts.
Dividing a defined benefit plan (pension) can take longer than a defined contribution plan (401k) due to actuarial calculations that are required for the defined benefit plan. The complexity of the retirement plan itself can be another factor as well as the language in the divorce decree and the level of cooperation between parties. Be sure to follow up often with all parties involved to keep the process moving forward. Be assured that once a retirement plan administrator receives notice of a divorce proceeding, the participant spouse may not move or liquidate funds.
Implementing a Qualified Domestic Relations Order (QDRO) with a Defined Benefit pension plan
QDROs are implemented when the member spouse retires and elects to receive a monthly benefit, terminates participation, or requests a withdrawal of his or her net personal contributions. Depending on the plan terms, the receiving spouse has a few possible options on what to do with their funds:
- Rollover the funds – If the plan permits, the allocated funds may be rolled over into the receiving spouse’s own qualified retirement plan or IRA Rollover. There are many benefits for the receiving spouse to move funds to an IRA account following a divorce. Be sure to inquire with the plan administrator to confirm that this is an option.
- Leave the funds where they are – Distributions may be deferred until a future date, at which time the receiving spouse can elect what they would like to do. The funds would be held at the same financial institution as they were before the divorce proceeding.
- Receive regular distributions – A receiving spouse can elect to receive payments as if they were a standard plan participant (as long as they meet the plan’s age requirement).
- Receive a lump sum – A receiving spouse can withdraw their portion of the tax deferred account, although this can be costly when considering that there will be income taxes due on the distribution. This option may make sense but must be examined with a tax professional.
QDROs and Defined Contribution Plans
When implementing a QDRO with a 401(k), the member spouse’s account would simply be divided, and the receiving spouse would have a new 401(k) account in their name. Your advisor can coordinate with the plan administrator once the QDRO is filed and can assist with the implementation and movement of funds if required.
QDRO Financial Planning Considerations
The Internal Revenue Code section 72(t)(2)(c) allows a unique one-time opportunity for the receiving spouse to withdraw funds received from the member spouse’s qualified retirement plan – regardless of their age. Upon a divorce settlement, once the 401(k) has been divided using a QDRO, any immediate cash withdrawal made by the receiving spouse (not the member spouse) would be exempt of any 10% early withdrawal penalty that would otherwise be incurred. Note that these withdrawals would still be subject to ordinary income tax.
There are several nuances to using a 72(t)(2)(c) election pursuant to a divorce that must be considered such as the fact that this can only take place before rolling funds over from the initially divided account. Once the separated funds have been rolled over into another plan or a Rollover IRA, this opportunity would no longer apply. This planning opportunity could be useful for receiving spouses who need some additional liquidity but is not at retirement age. Note that the plan is required to withhold income taxes on any withdrawal.
Conclusion: Comprehensive Divorce Financial Planning
When finalizing a divorce, it is imperative to file the QDRO with the plan administrator even if there are no intentions of claiming benefits soon. The receiving spouse should begin the process immediately, since delaying a QDRO could potentially cost them valuable benefits or other delays. There is the risk of the receiving spouse forfeiting benefits or losing money if the member spouse retires, remarries, dies, quits, is fired, withdraws funds from plan, or takes out a loan before the QDRO is filed.
Although the filing of a QDRO can be time-consuming and result in additional legal costs, it is in the best interest of the receiving spouse to initiate this process and stay on top of it. Doing so will help secure these funds and protect their financial future.
Beyond creating and filing a QDRO, there may be many other financial planning considerations to review during a divorce. Dividing retirement accounts during a divorce important, however, cash flow analysis, estate planning, and income tax planning is also critical. Working with a qualified divorce financial planner and Certified Divorce Financial Analyst or CDFA® is critical to avoid potential pitfalls. Be sure to make the necessary inquiries and consult with a Round Table Wealth Advisor to identify any planning opportunities that may arise from this process.