Despite its unusual sounding name, a QDRO isn’t an alien from a science fiction movie or a geometric equation. In fact, QDRO stands for “qualified domestic relations order.” If you’re in the process of a divorce, a QDRO may provide for the transfer of assets in a qualified retirement plan to a nonparticipant spouse without incurring dire tax consequences.

Asset transfer complications

Getting divorced and dividing up assets is no easy matter. At least you can sell a house or car or certain other possessions and distribute the proceeds according to the ownership rights under law. But liquidating other types of property, such as assets in a qualified retirement plan, can be more complicated.

To add to the complexity, you must take taxes into account. Generally, distributions from a qualified plan like a 401(k) plan are subject to federal income tax at ordinary income tax rates, currently topping out at 37%. Furthermore, state income tax may apply to the payouts. And, if you take a plan distribution prior to age 59½, you must pay a 10% penalty on top of the regular income tax bite, unless a special exception applies.

A QDRO in action

This is where a QDRO can come to the rescue. It provides a relatively straightforward means of accommodating a transfer of qualified retirement plan assets.

A court with jurisdiction or another appropriate authority issues the QDRO. Essentially, the QDRO establishes that one spouse has a claim to some of the other spouse’s retirement plan accounts. Typically, the QDRO will state either a dollar amount or a percentage of assets that belongs to the spouse of the participant, called the “alternate payee” in legal parlance. It also specifies the number of payments to be made (or the length of time for which the terms apply).

A QDRO may be used for qualified plans covered by the Employee Retirement Income Security Act (ERISA), including 401(k) plans, traditional pension plans and various other plans. In contrast, IRA funds, which aren’t covered by ERISA, generally are disbursed according to the terms of the divorce agreement.

With an approved QDRO in place, the alternate payee doesn’t owe any penalty tax on distributions. Thus, you can arrange a lump-sum distribution or series of periodic payments penalty-free according to the order, regardless of your age.

A QDRO must provide certain information, including the names and addresses of both the plan participant and the alternate payee; the dollar amount or percentage of assets being transferred to the alternate payee; and other vital details such as the amount, form and frequency of payments. If required information is omitted, a judge won’t sign off on the order. Rely on your professional advisor to ensure that all formalities are met.

After a QDRO is approved by the judge, there’s still more work to do. The alternate payee must submit it to the administrator of the retirement plan. Every plan governed by ERISA must follow the authorized process for QDRO filings. After the plan administrator accepts the QDRO, it’s good to go.

Note that an administrator can take up to 18 months to complete the process. Therefore, the sooner you do the necessary paperwork, the better. Preferably, the QDRO should be finalized before the divorce. If the QDRO is rejected — for example, because it requires a lump-sum distribution and the plan doesn’t offer that option — it’s back to the negotiating table.

Available payment options

Assuming QDROs are allowed by the plan, the alternate payee will have payment options to consider. For starters, he or she can take a lump-sum distribution of the full amount. However, this may result in a higher overall tax liability than if the payments were spread out. Or, the alternate payee can arrange to receive regular payments just like the plan participant, thereby reducing the total tax hit.

Another option is to roll over the assets into another plan or IRA. If the usual requirements are met — for example, the rollover is completed within 60 days — no current tax is owed for the year of the transfer.

Finally, the alternate payee may leave the money where it is. If permitted by the plan, additional contributions to the account may be made in the future.

Seek professional guidance

Does a QDRO make sense for you? It depends on your situation. Turn to your professional advisor for guidance.