A Qualified Domestic Relations Order (QDRO) can be a powerful tool to help manage the division of marital assets and debts in divorce proceedings. Although QDROs are most commonly used to divide retirement accounts, other uses may not be as well known. Some of these uses are kind of “out there” – a bit crazy, and probably more work than they are worth, but some are absolute lifesavers.
In this blog post, we will discuss five lesser-known uses of QDROs that can help both parties in a divorce achieve the financial settlement they are seeking. By understanding the full range of applications for QDROs, divorcing couples can ensure that a fair division of assets is achieved. In addition, we’ll provide tips for navigating the QDRO process, so that you can be confident that your financial interests are being protected.
A QDRO can be used to make alimony tax deductible
One of the lesser-known yet very useful capabilities of a Qualified Domestic Relations Order (QDRO) is that it can be used to make alimony payments tax deductible. How? First, let’s rewind. A few years ago, tax laws were changed so that alimony is no longer deductible. Bummer, for the supporting spouse.
Now, the whole point of a QDRO is to transfer retirement funds without the tax burden falling on the employee-spouse. (Otherwise, every divorce would mean a massive withdrawal of 401(k) funds, followed by a huge tax and early withdrawal penalty.)
See where we’re going yet? Pay the alimony from pre-tax retirement funds via QDRO and those transfers will get the same tax treatment as the alimony used to – the payor isn’t taxed, the payee is taxed. Plus, the payee won’t get hit with early withdrawal penalties (QDRO transfers are exempt from that penalty). To set this up, you would need one of two types of plans:
- A pension plan that is already eligible for retirement pay. The QDRO can award a fixed dollar amount for a limited time or for life. This can even be added to the alternate payee’s share of the pension if you’re already doing a QDRO. (For example: if the alternate payee is already entitled to half of the pension, the QDRO could be written as “half plus ____(amount of alimony)” per month.)
- A 401k and a lot of QDROs. You can award a fixed dollar amount in a 401k QDRO. So, to pull off regular alimony payments, you’d just need a handful of QDROs (or an agreement on a one-time sum in lieu of alimony). You could pay alimony quarterly, annually, etc., but you’ll need one QDRO per payment, and courts are slow, so this can get exhausting and expensive for anything other than one-time or annual payments.
This is probably the oddest QDRO use, and doing multiple QDROs for regular alimony payments is probably more expensive in terms of time and legal fees than it’s worth in terms of tax savings. But, if you can work it out with your ex-spouse, it can mean significant tax savings and help both spouses come out of the divorce in a better financial position.
A QDRO can be used to clear up spousal support arrears
Second on our list of five things you didn’t know a QDRO could do is clearing up spousal support arrears. While a Qualified Domestic Relations Order (QDRO) can be used to split retirement assets between spouses as part of a normal property division, it can also be used to take a portion of the retirement assets to satisfy existing obligations, including spousal support arrears.
We’ve seen plenty of cases where a reluctant spouse hides assets, quits a job, and refuses to pay past-due support, but they typically do not think to hide their pensions or 401(k) plans. And we’ve seen some where the person wants to pay what’s due, but doesn’t have enough cash at the ready. The QDRO allows the retirement account holder to pay spousal arrears from their retirement funds, without tapping into other assets or income. This can be a great way to settle spousal support issues quickly and efficiently.
Keep in mind taxation here, however: the person receiving funds in a QDRO is taxed. So, if you use a QDRO to collect back support payments, the supported spouse is going to be hit with a big tax bill and get less than they deserve. One solution is to add twenty percent to the arrears to cover those taxes as a “close enough” estimate of the tax bill.
A QDRO can be used to clear up child support arrears
This one isn’t much of a secret – child support agencies all over the country are using QDROs for child support as we speak. Why? With one QDRO, you can often clear up thousands of dollars in existing child support arrears. This can be a great solution for parents who are struggling to pay off their arrears or for the custodial parent dealing with a stubborn deadbeat.
It is important to remember that most of the time, child support issues are handled by your local child support agency. If that agency isn’t involved, you may be able to do a child support QDRO on your own or with the help of a lawyer, but it is very uncommon. Most people involve the agency once payments fall behind.
Like spousal support arrears, you’ll need to keep in mind taxation here: the person receiving funds in a QDRO is taxed. So, if you use a QDRO to collect back support payments, the child is going to be hit with a big tax bill and get less than they deserve. One solution is to add twenty percent to the arrears to cover those taxes as a “close enough” estimate of the tax bill, which is standard practice for child support agencies that handle these types of QDROs.
A QDRO can allow married couples to split a retirement account – even if they aren’t really getting divorced
A QDRO is for divorces, right? Yes, but some couples use the process as a workaround to pull off a transfer without the early withdrawal penalties and potential tax savings.
How? Consult with a lawyer in your area first, but the theory goes like this:
- File for divorce.
- Ask the court to enter a QDRO transferring the funds. The receiving spouse can cash out at their presumably lower tax rate and without early withdrawal penalties, or roll the funds over.
- Ask the court to dismiss the divorce filing.
This is also a potential route for evening out retirement savings or planning, years ahead, for medicaid or medicare, by reducing the assets and retirement income of one or both parties.
A QDRO can allow BOTH parties to withdraw funds from a 401(k) without paying early withdrawal penalties
One of the most useful and often overlooked benefits of a Qualified Domestic Relations Order (QDRO) is the ability of the parties involved to withdraw funds from a 401(k) without paying the 10% early withdrawal penalty. Normally, that benefit falls only to the non-employee/alternate payee spouse. But, if there is an understanding between the parties, the alternate payee can receive more than their share, then kick some back to the employee-spouse. This can be a useful way to give both parties early access to retirement funds, with less tax and penalties, so that they can start their two new lives with more cash in hand.
Tricky Strategies Need Expert Guidance
Look, these are mostly workarounds and hacks. The QDRO was intended as a vehicle for splitting retirement accounts as part of a normal divorce – typically 50/50 – and not as an alimony tax hack. If you’re considering one of these strategies, think about the legal fees and time investment versus potential tax savings, and run everything by your CPA and lawyer before proceeding.
The QDRO is a powerful tool to ensure that your retirement assets are protected and distributed as you intended them to be. It can provide flexibility to change the terms of a retirement plan, as well as serve as a powerful tool to help you and your family make informed decisions about how to divide your retirement savings. It can be used to ensure that your retirement assets are distributed in the most tax-advantageous way possible as well. But before you rush to declare victory over the tax authorities, run the plan by experienced counsel first.