When people divorce, separating finances can get complicated. And if you’re getting divorced and your spouse has a company retirement plan, you will no doubt hear the term “quad dro” or QDRO.
What exactly is a QDRO? It’s an acronym for Qualified Domestic Relations Order which is a document that you will need to divide up a retirement plan without incurring taxes and penalties. (1)
Why is it necessary?
In short, it allows divorcing spouses to receive their share of the other’s retirement plan assets.
Once it’s determined how much money from the plan the soon to be ex-spouse is entitled to, the QDRO permits the ex-spouse to transfer those assets to their own account, and allows them to do it without creating a taxable event.
How does it work?
Let’s assume John and Mary, both age 50 are divorcing. John is self-employed and funds a SEP IRA in his name and Mary works for a corporation that offers a 401k plan for which she participates in. Let’s further assume that Mary has accumulated $500,000 in her plan while John has $300,000 in his SEP IRA.
In their marital settlement agreement, John and Mary have agreed to divide their retirement accounts equally. Since they have a total of $800,000, that means each will receive $400,000.
Obviously, to equalize these accounts, Mary will have to give John $100,000 of her 401k. How will she do this?
How can the retirement plan be accessed?
Remember, with the exception of some plans that allow “in service” distributions, Mary cannot even access the funds unless one of three things occurs. 1) Death, 2) separation of service, meaning she leaves the company for some reason, or, 3) a qualifying disability.
Even assuming she left the company, how would she transfer the funds to John? Could she
simply request a withdrawal of $100,000 and hand a check to John? If she makes this mistake, she will get hit with taxes and penalties.
Can she just tell John to put the money in his own retirement plan?
The answer is no.
To get the funds to John and do so without taxes and penalties, they will need a QDRO!
A QDRO is an order, generally made by a state-level court as part of a divorce or legal separation that allows a retirement plan to be split or divided so that the other spouse can receive his or her share of the marital assets without incurring penalties and taxes.
Two Parts to the Definition
This means it’s an order that deals with “qualified” retirement plans, but equally important that the order is “qualified” based on the plan administrator’s determination that the order meets the plan’s rules for the assets to be separated.
(A qualified retirement plan is one that “qualifies” for favorable tax treatment under ERISA. Retirement plans offered by most companies like 401k plans and pension plans are qualified plans.) (1)
2) Domestic Relations Order
A domestic relations order is a judgement or decree that relates to the provision of child support, alimony, or marital property rights for the benefit of a spouse or former spouse, or child or other dependent of the person divorcing.
To do this, the court allows that his share of the asset be paid to an “alternate payee”. That alternate payee must be the current or former spouse, child or a dependent of the participant in the retirement plan to be divided.
In short, it recognizes that alternate payee’s (John’s) interest in a participant’s (Mary’s) retirement benefits. (1)
Who “qualifies” it?
A domestic relations order is qualified by a plan administrator after the administrator determines that the order meets the plan’s rules for dividing up the plan. (2)
What is required for the domestic relations order to qualify?
The order must contain:
1) The formal name of the retirement plan
2) The name and last known mailing address of both the participant and the alternate payee (typically former, or soon to be former spouse)
3) The social security numbers of both parties
4) The participant’s plan identification number, assuming it is different from his or her social security number which it often is. Most company plans have their own “plan ID” number which must be referenced
5) The dollar amount or percentage of the plan benefits that are to be paid to the former spouse, and the method that was used to calculate the amount that will be paid. (1)
IF it is a “Defined benefit” plan which means it is a pension plan for which monthly payments will be made, rather than a lump sum, then the document must list the number of payments or duration/amount of time that the alternate payee/former spouse will be paid.
If a 401(k) plan is being divided, it will likely be only one or two payments. Possibly one for pre-tax monies and another payment for after-tax monies (if any)
If a pension is being divided, then the alternate payee (spouse) may be receiving regular monthly payments over a period of years.
The QDRO will spell this entire out.
Do ALL retirement plans require a QDRO?
You don’t need a QDRO to divide IRAs, tax-deferred annuities, or government retirement plans like military, federal, state, county, or city pensions or retirement plans. (3)
You DO need a QDRO to divide:
- 401(k), 403(b), and 457 plans
- profit-sharing plans
- money purchase plans
- thrift plans
- employee stock ownership plans
- TSAs (tax-sheltered annuities often available to teachers and other non-profit organizations)
- business/corporate defined benefit or pension plans. (3)
A QDRO only applies to plans covered by ERISA.
What’s ERISA? The Employee Retirement Income Security Act that covers private sector pension and retirement plans.
There are other orders similar to QDROs that cover the division of military, Federal or state or municipal retirement plans.
Who should prepare the QDRO?
QDROs may seem easy to prepare, however rules that govern QDROs and retirement plans are complex and constantly changing.
A QDRO must be drafted to meet specific legal criteria for the particular plan it’s supposed to divide. Using a cookie cutter approach to a QDRO can result in an incorrect division of benefits, and loss of rights under a plan, AND a loss of benefits when the participant dies.
Experienced family law attorneys often don’t prepare QDROs and outsource to QDRO professionals. Just as doctors refer to other specialists. The bottom line – if you need a QDRO, hire a QDRO attorney. (3)
What happens next?
Once prepared, the QDRO, it must be approved by the court, and then the document is sent to the HR or payroll department of the 401k plan so the plan administrator can review the document and make sure it’s complete. For professionally prepared QDROs this is rarely a problem.
How is the payment of benefits made to the alternate payee/former spouse?
If a plan allows lump-sum distributions (like 401(k) and profit-sharing plans typically do) the alternate payee can receive their share in a lump sum payment and do a rollover to their IRA or other eligible plan.
They simply direct the plan administrator to make the check payable to their IRA or plan and incur no tax on the transfer.
And this is really the whole point. To enable the spouse to receive his or her share of the divorcing spouses benefit without tax or penalty. (4)
Defined benefit plans and pensions generally pay benefits in monthly installments. With these types of plans, the alternate payee will typically receive monthly payments for a set period of time.
The alternate payee or recipient will then direct the plan administrator to issue a check to his IRA or some other qualified plan to complete a tax free rollover so that the recipient isn’t taxed. This is a huge benefit that allows the couple to divide these assets so that there is no tax liability.
Feel free to call us for more information if you’re in the process of dividing up a plan.
(1) US Department of Labor at https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/faqs/qdro-overview
The opinions voiced in this article are for informational purposes only, and are not intended to provide investment, legal or tax advice or recommendations, and do not constitute an endorsement by Sagepoint. Please consult with your legal or tax professional.
Examples used as hypothetical illustration only, actual results will vary.