What If The Client Gets A Divorce? Advisors should know about the Qualified Domestic Relations Order
By Jane Warner
Divorce happens. When a long marriage ends, and assets are divided, qualified plans are usually also divided. Questions arise regarding assignment, pledges and alienating plan benefits. Poorly drafted property division settlements and failure to divide qualified plans properly using a Qualified Domestic Relations Order (QDRO) seriously can affect the retirement of one or both spouses.
When marital assets are divided, Internal Revenue Code Sections 401(a)(13)(B) and 414(p) allow a QDRO-mandated judgment to divide qualified plans. A QDRO may specify a spouse, former spouse, child or other dependent of the plan participant as an “alternate payee” of the qualified plan. A QDRO must include specific requirements or a plan division will be disregarded and unwanted tax consequences may occur.
Every QDRO must:
–relate to a provision for child support, alimony, or property rights;
–be made under the states domestic relations law;
–create, recognize or assign the right to receive all of a portion of the plans benefits; or
–be clear regarding the names of the plan, the participant, alternate payees, amounts or percentages of the division, dates of payments and/or payment inception.
QDRO rules apply to the division of all types of qualified plans, including 457 plans due to divorce. IRAs, including SEP, SIMPLE and/or Roth IRAs, must follow IRC 408(d)(6), which says a transfer to a spouse is tax-free if made pursuant to a divorce decree or a decree of separation or maintenance.
The tax consequences of the distributions that occur as a result of a QDRO, however, may differ, just as the distributions from various plans may differ.
QDRO distributions from 401(k), profit sharing and other 401(a) plans are subject to income tax as received and would be subject to the under-59 10% early withdrawal penalty, if applicable. Distributions from an IRA, while taxable, are not subject to the pre-59 distribution penalty if benefits are assigned under an IRC 414(p (1)) QDRO decree.
If a QDRO is planned properly, tax savings on plan distributions could result. For example, suppose:
Mr. C, age 50, 28% income tax bracket;
Mrs. C, age 50, 15% income tax bracket;
Mr. Cs plan balance = $50,000; and
QDRO transfer of $10,000 to Mrs. Cs IRA.
Mrs. C now has $10,000 in an IRA. Mrs. C can withdraw all of it. Her income tax will be at 15% or $1,500 and she will have net spendable income of $8,500. She does not incur an early withdrawal penalty.
Without the QDRO, Mr. C would have had to take a distribution to give $10,000 to Mrs. C. In that case, he would have paid $2,800 in income tax and a $1,000 early withdrawal penalty. To effectively transfer a full $10,000, Mr. C would have to make a much larger withdrawal to net even the $8,500 that Mrs. C could receive if the QDRO were in place.
When doing financial planning for a client who is divorced, one would naturally review qualified plan and other retirement accounts for potential amounts of income at retirement age. Knowing whether a QDRO exists can enhance your ability to provide income or liquidity enhancements to a divorced clients estate plan.
Sometimes a QDRO does not exist. Any agreement that is made pursuant to a divorce is not necessarily considered a QDRO. Ultimately, the plan administrator is required to determine if a court order is a QDRO.
If you are planning with the qualified plan participant client who has a QDRO, consider the following:
? How much has the retirement plan benefit been “reduced”?
? What strategies can best aid the client to rebuild lost retirement income? How long will it take? Will an early death leave children deprived? And how can the client avoid that?
? At the death of the participant, will there be a sufficient after-tax legacy or could the participant leverage some of the remaining plan money so that he or she creates an income and estate tax-free legacy for children or other heirs? This can be especially important where a divorce involves minor children who will require full support for many years, college funds, etc.
Clearly, rebuilding requires further investment and only can happen if the client has the funds to invest. However, protecting against an early death can be a smart part of the financial plan if life insurance is purchased as a part of the rebuilding plan.
Permanent life insurance that can develop high cash values fast can help the client save for retirement, provide some income tax-free funds if the client lives to retirement and yet still protect against an early death.
Unfortunately, divorces that split qualified plans are not routine court matters. Frequently, QDROs are not established or they dont satisfy the necessary requirements. In some cases, clients never know that qualified plan anti-alienation rules are violated until the tax consequences hit them. For example:
An amendment to a divorce decree may not constitute a QDRO, making a transfer to the divorced spouse a distribution from the qualified plan taxable to the plan participant. (Samaroo v. Samaroo, 193 F.3d 185(3rd Cir. 1999.))
A divorce decree ordering a plan distribution as part of the marital settlement may not meet the qualifications of a QDRO. It may be regarded as part of a property settlement. Again, taxable distributions and penalties may apply. (Hawkins v. Comm. 86 F.3d 982 (10th Cir. 1996.))
A court decree that does not meet the QDRO requirements may not be corrected into compliance at a later date. (U.S. v. Taylor, 338 F. 3d 947 (8th Cir. 2003.))
As an advisor, one might not always think of the consequences a divorce can have on retirement income. But understanding the QDRO and how it works can give the advisor a certain wisdom to help the client establish the correct strategies for future retirement income growth and estate protection.
Jane Warner, Esq. is director of advanced planning for the Individual Insurance Division of Sun Life Financial U.S., Wellesley Hills, Mass. She can be reached at [email protected].
Reproduced from National Underwriter Edition, October 7, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.