QDROs and divorce settlements: How QDROs can be used to divide property and assets in a divorce
A Qualified Domestic Relations Order (QDRO) is a court order that instructs a retirement plan administrator to pay a portion of a participant’s benefits to an alternate payee, such as a former spouse, child, or other dependent. QDROs are often used in divorce settlements to divide property and assets equitably between the parties.
QDROs can provide several advantages for both the participant and the alternate payee in a divorce. For the participant, a QDRO can reduce their taxable income by transferring some of their retirement benefits to the alternate payee, who will be responsible for paying taxes on the distributions they receive. For the alternate payee, a QDRO can provide a source of income and financial security in retirement, especially if they have limited or no retirement savings of their own. Additionally, a QDRO can protect the alternate payee’s rights to receive benefits in case the participant dies, remarries, or changes jobs.
However, QDROs also have some limitations and challenges that need to be considered. QDROs (and other retirement division court orders for government retirement plans) are complex and must comply with the specific rules and requirements of each retirement plan, which may vary depending on the type of plan (e.g., defined benefit or defined contribution), the plan’s vesting and eligibility criteria, and the plan’s distribution options and restrictions. Furthermore, QDROs must be approved by both the court and the plan administrator before they can take effect, which can take time and incur legal fees.
Watch for QDRO Traps
The most common trap in QDROs is simply not understanding taxation. There are tax implications in every QDRO that need to be considered – one wouldn’t want to exchange $60,000 in a savings account for a $60,000 pre-tax 401(k) account, for example, as the value of that 401(k) after taxes is far less than $60,000 in cash. Before you assume your award in a QDRO will be worth a certain dollar amount, check with your accountant on the taxes.
Second, know the plan distribution rules and vesting status. For pensions, you often have to wait until the employee is at retirement age, and then you typically can only get a monthly pension check – lump sums are rare, and if available, usually a bad deal, financially speaking, compared to the monthly check. For deferred compensation accounts (such as a 401(k)), know what the employee’s vesting status is and address that issue in the QDRO. Most of these plans will partially vest with each year of service until an employee has been with the company for a few years, at which point he or she will reach fully vested status. If they leave or cash out the plan before then, they lose part of their balance. Most QDROs will attempt to mirror vesting status between the parties so that both people have equally risky shares of the plan, though some plans do not allow splitting of unvested funds.
Types of Retirement Plans That Can Be Divided in a Divorce
There are different types of retirement plans that can be divided in a divorce, depending on whether they are qualified or non-qualified plans. Qualified plans are those that are regulated by the Employee Retirement Income Security Act (ERISA) and offer tax benefits to the participants. Non-qualified plans are those that are not subject to ERISA and do not have the same tax advantages.
Some examples of qualified plans are 401(k), 403(b), 457, pension, and profit-sharing plans. These plans can be divided in a divorce using a court order called a qualified domestic relations order (QDRO), which instructs the plan administrator how to distribute the benefits to the former spouse. The QDRO must specify the amount or percentage of the benefits, the duration of the payments, and the name and address of the alternate payee. The QDRO can also address issues such as survivor benefits, early retirement options, and cost-of-living adjustments.
Some examples of non-qualified plans are individual retirement accounts (IRAs), Roth IRAs, and government retirement plans. IRA plans can often be divided in a divorce using a bank process called transfer incident to divorce, which does not require a QDRO. The transfer incident to divorce is a tax-free rollover of the funds from one spouse’s account to another spouse’s account of the same type. For example, a traditional IRA can be transferred to another traditional IRA, but not to a Roth IRA. For government retirement plans, the most common division method is a court order that looks almost exactly like a QDRO – it’s just given a different name because the plan is administered by the government.
Process for Dividing Assets and Property with a QDRO
The process for dividing assets and property with a QDRO involves several steps:
- Identify the retirement plans that are subject to division. Not all retirement plans are eligible for a QDRO, so it is important to consult with a lawyer or a financial planner to determine which ones are. Some plans may have specific rules or procedures for QDROs that need to be followed.
- Negotiate the terms of the division. The parties can agree on how to split the retirement benefits, either as a percentage, a dollar amount, or a formula. The terms should also specify when and how the payments will be made, and whether the alternate payee will receive any cost-of-living adjustments, early retirement subsidies, or other benefits. The parties can also decide whether the QDRO will apply to the entire plan or only a portion of it.
- Draft the QDRO document. The QDRO document should include all the information required by the plan administrator and the court, such as the names and addresses of the parties and the plan, the amount and duration of the payments, and the designation of the alternate payee. The QDRO document should also comply with the applicable federal and state laws and regulations.
- Submit the QDRO document for approval. The QDRO document must be approved by both the plan administrator and the court before it becomes effective. The plan administrator will review the QDRO document for compliance with the plan rules and ERISA (Employee Retirement Income Security Act), and may request changes or clarifications if needed during a “pre-approval” stage. The point of pre-approval is essentially to get an answer to “if everyone signs this, can the plan execute the terms of the order?”
- Once it has been pre-approved and signed by the parties, the court will review the QDRO document for consistency with the divorce decree and other legal requirements, and may hold a hearing if there are any disputes or objections.
- Implement the QDRO document. Once the QDRO document is approved by both the plan administrator and the court, it becomes a binding order that directs the plan to pay benefits to the alternate payee according to the terms of the QDRO. The plan administrator will notify both parties of the effective date of the QDRO and provide them with statements of their account balances and payments.
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