Although the entry of a decree of divorce or legal separation frequently ends much of the strain of the legal proceedings, it doesn’t always signal the end of the work that is necessary to wind up all outstanding issues.
Common among the end-of-divorce tasks is the drafting and implementation of a Qualified Domestic Relations Order (QDRO), the legal document that instructs a retirement plan administrator on how to divide a spouse’s retirement account according to the terms set forth in the divorce or separation decree.
By the time what many presume to be the end stage of the divorce proceeding is reached, there is a tendency by both sides to want to conclude matters quickly, without incurring additional divorce attorney fees.
The perception is that negotiations concluded weeks or months ago, and the formalities of a QDRO are nothing more than signing a form document provided by the plan.
The reality is often otherwise.
Failure to have the proper legal representation throughout the QDRO process can result in adverse consequences to one or both of the parties.
QDROs are necessary because retirement plan benefits are non-assignable, meaning that the Plan Administrator is prohibited by law from paying out benefits to anyone other than the employee during the employee’s lifetime.
A QDRO is an exception to this rule. With a proper QDRO, the Plan Administrator is authorized (subject to the rules of the plan) to pay benefits to a spouse, former spouse, child, or other dependent to satisfy an order for property division, alimony, or child support.
QDRO Tax Advantages
A QDRO also has practical tax advantages to the employee-spouse.
As an example: Husband has a 401(k) plan with a $100,000 balance.
If Husband takes a $50,000 distribution to pay to Wife pursuant to their divorce agreement, Husband will incur a 10% early withdrawal penalty, and Husband must pay income taxes on the distribution.
Assuming an effective tax rate of 20%, Husband would incur $15,000 in taxes and penalties on the $50,000 payment to Wife.
Alternatively, if Husband transfers $50,000 to Wife via QDRO from his 401(k) plan, there are no tax consequences to Husband.
Wife would have the choice to either cash the monies (which avoids the 10% early withdrawal penalty, but still triggers to Wife the payment of taxes on the distribution), or Wife can keep the monies in a qualified retirement account (e.g., an IRA) and continue deferring the tax consequences.
The Importance of a QDRO
Quite often divorce agreements do not fully address the division of the plan’s benefits.
Depending on the nature of the plan, during the QDRO drafting process disputes arise about vesting issues, 401(k) loans, the allocation of fees charged by the plan, accounting for pre-marital interests, survivor benefits for the former spouse, division of cost-of-living adjustments and early retirement subsidies, and the proper calculation of an award from a pension plan.
If the divorce agreement is silent, then there may be additional delays until these issues are resolved.
For these reasons, it is vitally important to seek competent legal counsel early in your case in order to ensure that the plan benefits are properly divided and to avoid delays and additional legal costs.