Divorce & Taxation of Retirement Benefits

Tracking revenue

When married couples separate there are a lot of practical issues that must be addressed along with the emotional ones. Since most couples live together during the marriage, there is usually the problem of how to divide the equity in a home. Slightly trickier, at least for purposes of taxation, is how to divide tax sheltered retirement assets like 401(k), Keogh, SEP and IRA accounts. Fortunately, Congress has provided a mechanism for splitting these assets without giving up the benefit of tax deferral.

QDROs in a Nutshell

Wedding rings

Long ago, Congress recognized that there should be a way to split tax deferred retirement accounts without first withdrawing the funds in those accounts thus incurring early withdrawal penalties and triggering taxation as though the withdrawals were part of one or both parties' current income. The vehicle they devised for making such divisions is known as a Qualified Domestic Relations Order, more commonly known as a QDRO. The statutes that authorize the division of funds in this manner are part of the United States Tax Code.

Types of Retirement Accounts

There are many types of tax-deferred retirement accounts all of which carry penalties for early distribution. The most common are the 401(k) account and the individual retirement account or IRA. Other tax deferred retirement accounts include Keogh plans for profit sharing and Savings Incentive Match Plans known as SIMPLE
IRAs.

QDRO Qualification

To qualify as an instrument for dividing a tax-deferred retirement account, a court order must be determined to be qualified for special tax treatment by the administrator of the retirement account that is to be divided. While there are certain statutory requirements such as proper identification of the plan and participant as well as of the alternate payee to whom funds are to be transferred, there are other technicalities that are overseen by the individuals or organizations responsible for actually carrying out the transfers in individual cases. Parties to the divorce, or their lawyers, therefore draft qualified domestic relations orders and then submit them for review by the retirement plan administrator who actually handles the account to be divided.

Processing the QDRO

Once the plan administrator has approved a draft QDRO it is circulated among counsel involved in the divorce, or if one or more parties is unrepresented, to the parties themselves. After the terms of the order are agreed upon and the document has been signed by the parties or their representatives, it is forwarded to the family court where the divorce was finalized for signature of a judge. After that it is returned to the plan administrator to be executed.

The Fate of the Transferred Funds

Funds that have been shifted to an ex-spouse of a retirement plan participant may be handled in a number of ways. Often the new owner--now termed the 'alternate payee'--may choose to leave the funds in the control of the same plan administrator. In other cases, the new owner opts to direct the plan administrator to roll the funds over into a different tax-deferred investment like her own 401(k) or an IRA that she already owns or one that has been opened for the sole purpose of receiving the funds.

Using Retirement Funds Transferred by QDRO

The rules that applied to the original owner of a tax-deferred retirement account apply equally to the new owner. This means that if the new owner or alternate payee wants to withdraw and use the funds immediately and she is not yet old enough to withdraw the funds tax free or is not withdrawing them for a specified allowable purpose, the withdrawal will be taxed as current income and there will be a penalty imposed, as well, for early withdrawal.

References

• The Basics of Pension All Pro QDRO: Plans to Aid in the Preparation of a QDRO