If there is a retirement account or pension plan that is to be divided after your divorce, it is probable you will need a Qualified Domestic Relations Order (QDRO), in addition to your settlement agreement or divorce decree.
A QDRO is a document that instructs a retirement plan administrator on how to pay the non-employee spouse’s share of the plan benefits. In some cases, the marital portion of the retirement account might be split 50/50. In other cases, such as with a defined contribution plan, the QDRO may refer to a specific dollar amount to be awarded to the non-employee spouse.
The most common types of retirement accounts that usually require a QDRO in order to divide them are defined contributions plans — such as 401(k) and 403 (b) accounts — and pension plans. Certain types of pensions require a Domestic Relations Order (DRO) instead of a QDRO.
An Individual Retirement Account (IRA), which is another common type of retirement plan, typically does not require a QDRO in order to divide it.
Without a QDRO, if the spouse with the defined contribution plan withdrew money to pay the non-employee spouse, he or she would be taxed on the withdrawal. Furthermore, if the employee had not yet reached retirement age (in most cases 59 and a half), he or she would also have to pay a 10% penalty.
For example, if a 401(k) worth $100,000 was supposed to be split in half by a 50-year old husband in a combined 30% state and federal tax bracket, it wouldn’t be fair to give $50,000 to his ex-wife. That’s because after paying taxes and the 10% early-withdrawal penalty he would only have $30,000 to give to his ex-wife. She would not be happy about that if she was expecting $50,000. However, if a QDRO was properly drafted and accepted by the plan administrator, the ex-wife could receive $50,000.
Sometimes divorcing parties are so ready to be done with their divorce and paying legal fees they never get around to having a QDRO drafted. For a pension plan in particular, this can be disastrous if the employee spouse dies after the divorce is finalized but before the QDRO was submitted to and accepted by the plan administrator. The non-employee spouse who was counting on monthly payments for life may never receive even one check!
As a financial advisor, I typically recommend if a defined contribution plan such as a 401(k), or 403(b) is split, the recipient should request the funds be rolled into an individual retirement account (IRA). This approach means none of the money is taxed at the time of transfer. This also allows the funds to be invested (and grow tax-deferred) with nearly any bank or brokerage firm and not limited to the few mutual funds that might be available in the employee-spouse’s employer’s plan.
If you don’t feel comfortable deciding what to invest in, this would be a great time to meet with a financial advisor. Many of my current clients have come to me to manage the investments for their share of the retirement assets they receive after the QDRO process is finalized. They open an IRA and I teach them about stocks, bonds, and asset allocation.
It is possible, in some cases, for a QDRO to be drafted that enables the recipient to receive a cash distribution instead of rolling over the proceeds into an IRA. In these cases, federal and state income taxes would be assessed on the recipient but the 10% early-withdrawal penalty would be waived. Unfortunately, this can get botched if you don’t use a QDRO expert to draft the QDRO.
Most divorce attorneys do not prepare the QDROs themselves so you need to find a QDRO specialist, many of whom are also attorneys. Some charge by the hour and some charge a flat rate.
There are ways to draft a QDRO yourself, without an attorney. However, each retirement and pension plan has very specific requirements for the language to be included in the QDRO and will get rejected otherwise. This can cause months (and sometimes years) of delay. You want to make sure it is done right the first time. This article explains some of the things that can go wrong. Having worked on over 100 divorce cases, I have seen some of the big mistakes.
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