Dividing retirement accounts in divorce with a Qualified Domestic Relations Order
Unlike dividing bank accounts, for example, dividing retirement accounts in a divorce can present some special challenges. This is because of the numerous rules that govern how money can be distributed from retirement accounts like 401(k)’s or IRA’s. This article will help you understand some of the issues involved in dealing with retirement accounts in divorce.
Penalties and taxes
There are two primary concerns when talking about taking distributions from a retirement account. The first is a 10% additional income tax (a penalty, really) on early withdrawals made before age 59 1/2. However, there are various exceptions that may allow withdrawals to be made before this age without a penalty. The second issue for clients to consider is other tax that may be due, apart from whether there is any penalty.
Avoiding the penalty for early withdrawals by using a QDRO
Probably the most common way of avoiding the early withdrawal penalty in a divorce is to use a Qualified Domestic Relations Order (“QDRO” – pronounced kwah-droh).Tax rules provide that if a distribution from a spouse’s qualified retirement plan, (e.g. 401(k)) is made to the other spouse via a QDRO (Qualified Domestic Relations Order), then the distribution would not be subject to the 10% penalty. Specifically, Internal Revenue Code Section 72(t) allows the penalty to be avoided if:
- The person receiving the distribution is not the titled “owner” of the plan. The recipient of the distribution must be the non-owner, or “alternate payee.”
- Further, the plan has to be a qualified plan that is governed by ERISA. Many employer sponsored retirement plans such as 401(k) plans or 403(b) plans qualify under this definition. However, it is important to realize that Individual Retirement Accounts (IRAs) do not.
- A QDRO must be used to divide the plan and make the distribution.
The QDRO is an order that is entered in the divorce case. Typically the terms of the distribution will be spelled out in the Final Decree of Divorce and/or Property Settlement Agreement. Once the judge in the divorce case signs the QDRO, the QDRO will be sent to the administrator of the retirement plan. At this point, the administrator will review the QDRO to determine if it complies with the applicable rules.
If the QDRO is approved by the plan administrator, then the retirement plan will make arrangements for distributing the funds to the alternate payee. Typically the alternate payee may choose to roll the funds he or she receives over into a new retirement account (like an IRA), or the alternate payee can choose to receive the funds directly. It is important to note that if the alternate payee does choose to receive the funds directly (and not in a rollover to another retirement account), he or she will not have to pay the early withdrawal penalty, but other taxes may be due on the distribution.