Divorce and retirement plans  

Many domestic proceedings involve the division of retirement assets. With more than 80 million workers in the U.S. being covered by an employer-provided retirement plan, retirement savings represent a significant asset for many Americans. And when spouses divorce or separate, dividing up these marital assets can be challenging, especially when it involves a spouse’s interest in a qualified retirement plan that is subject to favorable tax treatment.

While the division of marital property is governed by state domestic relations law, retirement plans are also governed by federal law—specifically, the Employee Retirement Income Security Act of 1974 (ERISA), the Internal Revenue Code of 1986 (IRC), and the Department of Labor’s Employee Benefits Security Administration (EBSA) rules. Under these federal laws, retirement benefits may only be assigned to an alternative beneficiary pursuant to a judicial order, decree, or judgment that creates or recognizes a current spouse’s, former spouse’s, child’s, or other legal dependent’s interest in a plan participant’s retirement benefits.  This is known as a “Qualified Domestic Relations Order” (QDRO).

 What is a QDRO?

Let’s first explore: what is a QDRO? In short, a QDRO is a legal document (in the form of a decree, judgment, or order issued by a court, often as part of a divorce agreement) that splits up a retirement plan between the plan participant and an “alternate payee.”  A retirement plan may include, among others:

• A private pension plan;
• A 401(k) plan;
• A 403(b) plan;
• A 457 plan;
• An employee stock ownership plan (known as an ESOP); or
• A defined benefit plan

A QDRO recognizes that a current or former spouse, child, or other legal dependent is entitled to receive a predefined portion of the account owner’s retirement plan assets as part of alimony, spousal maintenance, child support, or marital property rights.

To be effective, it must contain specific information, including the name of the plan participant, the name and last known mailing address of each alternate payee, the amount or percentage of the participant’s benefits to be paid to each alternate payee, and each plan to which the QDRO applies.

Any benefits or options awarded to an alternate payee must be allowed under the retirement plan.  Also, the QDRO cannot require the plan to provide increased benefits that are determined based on actuarial value, and cannot require the payment of benefits to an alternate payee that are required to be paid to another alternate payee under another QDRO.

In a divorce context, the QDRO allocates a share of the participant’s cost to the spouse.  This share is computed as a fraction, with the numerator being the present value of the benefits payable to the spouse, and the denominator being the present value of all benefits payable to the participant. The former spouse is treated in the same manner as a surviving spouse as long as they were married for at least one year. Once the QDRO is issued by the court, the plan administrator must notify the plan participant and each alternate payee within a reasonable time of receiving the order.

QDROs can assign rights for more than one plan.

Community property and QDROs

Retirement assets gained during the marriage are treated as marital assets and property of the marital estate. When distributing retirement assets, state domestic relations law will yield to federal law.  A court can order the redirection of retirement benefits to an alternate payee. When the court is determining how to equitably divide marital assets between the spouses, retirement accounts are treated no differently than other assets, like a car or checking account. However, because retirement accounts can hold significant value, the court may have give special consideration to how the retirement plan should be divided.  In community property states, which includes Texas, any income made during the marriage is not distinguished by who made it but is considered the property of the marriage and owned equally by both spouses.

For retirement plans, Texas law dictates that courts determine the rights of both spouses in a pension, retirement plan, annuity, individual retirement account, employee stock option plan, stock option, or other form of savings, bonus, profit-sharing, or other employer plan or financial plan of an employee or a participant, regardless of whether the person is self-employed, in the nature of compensation or savings. For a property interest in certain employee benefits, the separate property interest of a spouse in a defined contribution retirement plan may be traced using the tracing and characterization principles that apply to a non-retirement asset. If the retirement plan is a public one run by the state, then the appropriate state law will apply.

Domestic relations courts will need to determine the basic category and type of retirement plan involved in the proceeding.  Identifying the type of retirement plan will determine which provisions of the IRC will apply as well as the controlling state property law that governs it. Qualified retirement plans receive favorable tax treatment, so a QDRO will assign a portion of benefits to the alternate payee while allowing the plan to continue as a “qualified” retirement plan under ERISA. To avoid further litigation after the death of the plan participant by the ex-spouse and any additional (ex)spouses, the QDRO should order the plan participant to update the beneficiary designation on the retirement plan.

State law determines the distribution of the retirement plan whereas federal law determines the federal income tax liability as well as the consequence of assignments and transfers of marital property. To protect plan participants, the IRC has specific restrictions on plan administrators, the plan participants, and on the benefits themselves.

QDROs and Tax Implications

Divorcing spouses and domestic support orders will often have to deal with federal tax consequences, including a QDRO and any federal pensions.  In general, ERISA and the IRC do not permit a retirement plan participant to assign their interest to an alternate payee. The law was designed this way to ensure that the plan participant’s benefits are available to them during their retirement years. However, the law creates a limited exception for QDROs. Under this exception, some or all of an individual’s retirement benefits may be assigned to a current spouse, former spouse, child, or other legal dependent.

Regarding tax obligations, the beneficiary of a QDRO must report any payments received. For a current or former spouse, they report the payments received as if they are a plan participant.  Once a distribution is made, the recipient must either (i) accept the distribution, in which case they will be responsible for paying any applicable taxes to the IRS, or (ii) roll over the payment into another retirement account, assuming the distribution was made before the recipient reaches 59.5 years of age. Distributions made before 59.5 years of age would normally trigger a 10% early distribution penalty, but distributions from a QDRO which are rolled into a qualified retirement plan will avoid this penalty.   Distributions to a child or other dependent will be taxed to the plan participant.

Creating a QDRO can add expense to divorce proceeding, especially if it’s not done correctly.  It can also create tax issues for divorcing spouses. 

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