When a couple divorces, one of the most complex and contentious issues they may face is how to divide their retirement plan assets. Retirement plans are often a significant part of a couple’s marital estate, and they may have different rules and regulations depending on the type of plan and the employer sponsoring it. In order to divide retirement plan assets in a divorce, a special court order called a qualified domestic relations order (QDRO) may be required, while other plans may require a similar court order or simple bank transfer paperwork.
When to Use QDROs, Court Orders, or Bank Forms
A QDRO is a court order that says an alternate payee (like a spouse, ex-spouse, or child) has the right to get all or part of the retirement plan payments. A QDRO must meet the standards of the Internal Revenue Code, the Employee Retirement Income Security Act (ERISA), and the plan’s terms and conditions. A QDRO can only apply to plans that are subject to ERISA, such as 401(k) plans, pension plans, profit-sharing plans, and some 403(b) plans.
A QDRO cannot apply to plans that are not subject to ERISA, such as individual retirement accounts (IRAs), Roth IRAs, SEP IRAs, SIMPLE IRAs, government plans, military plans, and some church plans. However, a court can still issue an order to divide these plans – an order that looks a lot like a QDRO but doesn’t share the same name because it doesn’t fall under ERISA. For example, most state plans will be divided by a DRO (Domestic Relations Order). Some federal plans may be divided by a COAP (Court Order Acceptable for Processing) or a RBCO (Retirement Benefits Court Order). The plethora of names is a bit silly, but the important thing to remember is that all of these orders are trying to do the same thing: divide retirement assets correctly and without triggering unintentional tax consequences.
And we’d be remiss to not mention the IRA shortcut – bank forms. If the parties are cooperative, IRA plans do not require a formal court order to divide in most circumstances. Instead, the parties can ask the bank for a “transfer incident to divorce” form, which bypasses the court process and still avoids the tax consequences.
Division Methods for Pensions and Deferred Compensation Plans
The division of retirement plan assets in a divorce depends on several factors, such as the type of plan, the date of marriage and divorce, the value of the plan at different points in time, and the method of calculation chosen by the parties or the court.
The easiest place to start is pension or deferred compensation plans. For pensions, there are three main methods of calculation: the coverture fraction method, percentages, and fixed dollar amounts. Coverture is the most common and fairest method and it essentially is a formula that converts service time during the marriage into a percent of each check (plus cost of living adjustments and the like) at the time of retirement. A percentage award is exactly what it sounds like – a percentage of each check. And fixed dollar awards, similarly, come out of each check.
The coverture fraction method is based on the principle that only the portion of the retirement plan that was accrued during the marriage is subject to division. The coverture fraction is calculated by dividing the number of years or months of marriage during which the participant was in the plan by the total number of years or months of service in the plan. The coverture fraction is then multiplied by the value of the plan at the time of distribution to determine the marital portion. The alternate payee typically receives a percentage of the marital portion as specified in the QDRO.
For deferred compensation plans, the calculations often take the form of dollar amounts or percentages – 50% awards are extremely common, or if the parties have exchanged or offset property, they may have decided on a dollar amount instead. Keep in mind three more very important things to consider on deferred compensation QDROs:
- Depending on state law and your divorce settlement, you may have to account for a premarital share of the retirement account, plus whatever the stock market would have done to that share. So, if you had $10,000 as of the date of marriage, that $10,000 may have to be adjusted to “today’s dollars” and subtracted from the current plan value.
- For fixed dollar awards, your state may have a default rule about whether or not you hae to adjust that amount for stock market performance from the date of divorce to the day the money is actually paid out. Regardless of your state’s default rule, you should ask to put language in your settlement agreement addressing this issue so that there are no surprises.
- If a lot of time has passed since your premarital interest was accrued, or since your divorce, your retirement plan administrator may not have sufficient records to calculate the respective shares in the account. If this happens, you may have to hire an accountant to get a close-to-exact number or you may have to negotiate for a compromise amount with your ex-spouse.
The choice of calculation method may depend on various factors, such as the type and features of the plan, the age and life expectancy of each spouse, their respective income and tax situations, their preferences and goals for retirement planning, and their willingness to cooperate and negotiate. It is important to consult with a qualified attorney, financial planner, accountant, or actuary before deciding on a method or signing a QDRO.
Dividing retirement plan assets in a divorce can be a challenging and confusing process. A QDRO is a legal document that must comply with federal and state laws and with specific plan rules. A QDRO can have significant implications for both spouses’ financial security and tax liability. Therefore, it is essential to seek professional guidance and assistance from experts who specialize in QDROs and retirement plan issues.
