Dividing Up Retirement-Plan Assets with a QDRO

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from PPC Tax Planning Guide—Closely Held Corporations, 14th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Linda Ketter-Craig and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex. ((800) 323-8724; www.ppcnet.com).

Facts: Tom and Glenda Henderson's recent divorce decree awarded her $2 million in cash from his interests in various qualified retirement plans sponsored by his employer. The decree did not specify the qualified plan from which the payment should be made, nor did it list Glenda's last-known address. Issues: What are the tax consequences of this provision in the Hendersons' divorce decree?

Analysis

When qualified plan assets (e.g., interests in profit-sharing, pension or Sec. 401(k) plans) are divided in a divorce, a qualified domestic relations order (QDRO) is critical for two reasons. First, payment of plan benefits to a participant's spouse or former spouse (other than through a QDRO) may violate the anti-alienation rules and, thus, cause disqualification of the plan. Plan administrators are given a certain period to decide whether an order meets the technical requirements of a QDRO before actually assigning some or all of the participant's benefits to another party, or making distributions to someone other than the plan participant.

Second, without a QDRO, distributions to someone other than the participant are treated as paid to that person on the participant's behalf. Thus, the participant woud be taxed on the distribution as if he had received it and then given the cash to the ultimate recipient. The participant would receive no deduction for the deemed transfer to the former spouse. Distributions under a QDRO, however, would be taxed to the actual recipient if he were the participant's spouse or former spouse.

These separate but related problems can arise in divorce situations when a state court orders an assignment of plan benefits to a nonparticipant spouse. However, an assignment of qualified retirement-plan benefits in connection with a separation or divorce made pursuant to a QDRO solves these problems.

A QDRO is a judgment, decree or order (including one approving a property settlement agreement) that meets the following requirements:

1. It provides for child support, alimony payments or marital property rights for a spouse, former spouse, child or other dependent of a qualified-plan participant and is made pursuant to a state domestic relations law (including a community property law).

2. It creates or recognizes the existence of the right of the individual named in the first item (i.e., the alternate payee) to receive all or a portion of a participant's benefits under a qualified retirement plan.

3. It clearly specifies the following:

• The name and last-known mailing address of the participant and each alternate payee covered by the order.
• The amount or percentage of the participant's benefits to be paid by the plan to each alternative payee (or the manner in which such amount or percentage is to be determined).
• The number of payments or periods to which the order relates.
• Each qualified retirement plan to which the order applies.

However, a QDRO may not require the plan to do any of the following:

1. Provide increased benefits.

2. Pay benefits to an alternate payee that must already be paid to a different alternate payee under another QDRO.

3. Provide a type or form of benefit or any option not otherwise provided under the plan. (However, Sec. 414(p)(4) permits a QDRO to require the payment of "early retirement benefits" to an alternate payee even when the plan participant is not entitled to such benefits.)

Conclusion

Although the QDRO requirements are very specific and can be tedious to comply with, failure to strictly follow them can result in unplanned and adverse tax consequences. In this case, Tom and Glenda Henderson's divorce decree does not meet the QDRO requirements. Specifically, the decree does not specify the retirement plan to which the order applies, nor does it list Glenda's last-known address. Because the Hendersons' divorce decree does not qualify as a QDRO, Tom will be taxed on the full $2 million distribution, even though Glenda got the cash.

Variation

Assume now that the Hendersons' divorce decree met the QDRO requirements. When a divorce agreement is properly drafted to constitute a QDRO:

1. The alternate-payee spouse is taxed. A payee spouse who is the former spouse of the plan participant is taxed on the retirement plan distribution received. If, however, the distribution is made to some other recipient, it would be treated as a deemed distribution to the plan participant and taxed to that person.

2. The 10% penalty does not apply. The 10% early-distribution penalty tax does not apply to a distribution made pursuant to a QDRO. This exception applies whether the alternate payee is the plan participant's spouse, former spouse, child or other dependent.

3. Rollover treatment is allowed. If the alternate payee is the participant's spouse or former spouse, any distribution received by such person will qualify for rollover treatment as if the distribution had gone to the plan participant.

Note: If the alternate payee is under age 59¹/2, a distribution from a qualified plan pursuant to a QDRO, followed by a rollover to an IRA, might not be the best option. Any subsequent distributions before age 59¹/2 are normally subject to the 10% early-distribution penalty. If the plan allows, a better solution might be to leave the funds in a segregated account with the plan trustee. Distributions from the segregated account would not be subject to the penalty, even if made before age 59¹/2.

4. The participant's basis is allocated. If the alternate payee is the plan participant's spouse or former spouse, any basis the participant has in the plan would be allocated on a pro-rata basis between the present value of the alternate payee's interest and the total present value of all the benefits payable to the plan participant.

This means that if the plan administrator distributes the $2 million to Glenda, she could roll over that amount to an IRA within 60 days to avoid current tax. (Alternately, to avoid the 20% Federal income tax withholding on the distribution, she could arrange for a direct trustee-to-trustee transfer of the funds from the plan to her IRA.) Any amount received by Glenda and not rolled over is taxable to her, but it is not subject to the early-distribution penalty, regardless of her or Tom's age. Tom is not taxed on the distribution to Glenda, nor does the QDRO distribution affect his eligibility to make a rollover.

Practitioners and plan administrators often have difficulty drafting QDRO forms that the participants (and spouses) can understand, while still containing all the required information. To alleviate this problem, the IRS issued Notice 97-11, to assist domestic-relations lawyers, qualified-plan participants, spouses and former spouses of participants, and plan administrators in drafting and reviewing QDROs. The notice consists of two parts. The first part discusses the issues that should be considered in drafting a QDRO; the second part provides sample language that should be included.

While judges and divorce attorneys are generally aware of QDROs and how they are intended to work, they are often unaware of the specific QDRO language and information that must be included in the divorce papers. Tax advisers can provide a valuable service to their clients by working with the client's attorney to ensure that the order contains all of the necessary language.