A QDRO is a legal document or a provision included in another legal document such as a divorce-related property settlement or divorce decree. The QDRO establishes the right of a former spouse (also known as the alternate payee) to receive all or part of the other former spouse's qualified retirement plan benefits and pay the income taxes on those benefits. In other words, "he who gets, pays."
A QDRO is required to meet specific requirements set forth in Internal Revenue Code Section 414(d). Until the Hawkins decision the Internal Revenue Service had been successful in claiming that a failure to follow the statutory requirements to the letter resulted in the participant former spouse being taxed on a constructive distribution from the plan, which is than deemed given to the alternate payee. In other words, the alternate payee gets the cash, while the former spouse gets the tax liability.
Per Internal Revenue Code Section 414(p), a QDRO must meet all of the following requirements.
- It must provide for child support, alimony payments or marital property rights for a spouse, former spouse, child or other dependent of a qualified plan participant and it must be made pursuant to a state domestic relations law including a community property law.
- It must create or recognize the existence of the right of the alternate payee to receive all or a portion of a participant's benefits under a qualified retirement plan.
- It must specify 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 to each alternative payee (or the manner in which the amount or percentage is to be determined);
- The number of payments or periods to which the order relates;
- And each qualified retirement plan to which the order applies.
- To be a QDRO, an order must not:
- Require the plan to pay increased benefits;
- Require the plan to pay benefits to a "new" alternate payee when a previously named alternate payee is already entitled to those benefits; or
- Require the plan to provide a type or form of benefit or any option that is not otherwise provided for by the plan. However Internal Revenue Code Section 414(p)(4) does provide an exception that permits a QDRO to require the payment of "early retirement benefits" to a alternate payee even when the plan participant is not entitled to such benefits.
The tax outcome of using a QDRO is what the divorcing couple would expect. The alternate payee is taxed on the funds when the funds are withdrawn from the retirement plan account, but the 10 percent early distribution penalty tax doesn't apply [Internal Revenue Code Section 72(f)(2)(C)]. Alternatively, the distribution can be rolled over into an Individual Retirement Account (IRA) owned by the alternate payee without incurring income tax, if the alternate payee is the spouse or former spouse rather than child or other dependent of the participant. However, the rollover must be done within 60 days of the alternate payee's receipt of the QDRO distribution from the qualified plan. To avoid the 20 percent federal income tax withholding that will be taken out of a QDRO distribution, you should have the transfer made directly to the trustee of the IRA from the trustee of the qualified plan.
The disastrous tax effects of not using a QDRO to split up qualified retirement plan benefits are illustrated by the original Hawkins decision. Arthur Hawkins was an orthodontist in New Mexico. Under the divorce settlement agreement, Arthur's former spouse was awarded $1,000,000 to be paid from his qualified retirement plan Arthur was the plan administrator and sole trustee.The Internal Revenue Service claimed the QDRO requirements were not met. According to the Internal Revenue Service, the settlement agreement did not establish the wife's right to plan benefits with the meaning of Internal Revenue Code Section 414(p) because it did not specifically use the term "alternate Payee." In addition, the former spouse's last known address was not sent forth in the document. The Tax Court agreed with the Internal Revenue Service that the $1,000,000 payment to Mrs. Hawkins should be treated as a distribution to Arthur. The resulting tax deficiency to Arthur was $384,792, even though he got none of the money.To no one's surprise, Arthur appealed to the 10th Circuit. At that level he won. The Appeals Court determined that the former spouse's legal right to qualified plan benefits was clearly defined in the settlement agreement; the amount of $1,000,000 was specified and was ordered to be paid immediately. Since Arthur was the plan administrator and the former spouse stipulated that he did not have her last known address, the alternate payee name and address requirement was deemed satisfied. Therefore, the language in the settlement agreement was sufficient to establish a QDRO.While things turned out to Arthur's advantage in the end, it took years of expensive litigation to get there. Therefore the moral of this story is not "it's better to be lucky than good." The real moral is: Make sure the QDRO requirements are undisputedly fulfilled in the first place.
IRAs
Sec. 408(d)(6) treats the transfer of all or part of an individual retirement account (IRA) to a former spouse as a nontaxable event. The transfer must result from a decree of divorce or separate maintenance, or a written instrument incident to a divorce. The transfer is not treated as a taxable distribution for income tax purposes to either spouse. After the transfer, the IRA is treated in all respects as belonging to the recipient spouse. As the legal owner of the transferred IRA, only the recipient spouse can make contributions to the account. Contributions can be made from alimony as a substitute for the recipient spouse's compensation (Sec. 219(f)(1)).
Military retirement benefits
Under current law, state courts can decide whether military pensions are subject to property settlements. The Former Spouses Protection Amendment (P.L. 97-252) provides for direct payment to a former spouse for alimony, child support and property settlement. Although there are no length of marriage requirements for child support or alimony, such requirements do exist for medical benefits. Medical benefits are provided to former spouses married to service personnel for 20 years, but governmental payments to the spouse are available only when the couple was married for at least 10 years during the military spouse's creditable service. Also, a former spouse cannot recover more than 50% of a military spouse's pension incident to a divorce.
An exception to the Former Spouses Protection Amendment exists with military life insurance. In Ridgway v. Ridgway, 455 US 46 (1981), the Supreme Court held that a serviceman's right to designate the beneficiaries of military life insurance takes precedence over a state divorce court order awarding those benefits to minor children.
Essential Things to Remember Regarding Divorce and the Military:
- Federal law considers military retirement pay as marital property but states don't handle it the same way.
- A state court order is not enough to establish your benefits.
- You have only one year after the divorce to claim your share.
- If you remarry before you're 55, you lose the benefits.
- Benefits may be restored if your new marriage ends in death or divorce.
- According to federal law, divorce spouses are not entitled to the service member's disability pay.
- If you have been married at least 10 years and the spouse has the required amount of creditable service, the former spouse may be entitled to receive retirement pay directly from the Defense and Accounting Service office (www.dfas.mil)
- If you and your military spouse were married for 20 years or more then you are eligible for medical coverage. Your dependent children continue to receive coverage. Visit your regional TRICARE office, www.tricare.osd.mil, for info on eligibility.
Conclusion
Employee retirement plans are often a taxpayer's biggest asset and must be considered in planning for an equitable distribution of property. As part of a property settlement, there is no recognized gain or loss on a transfer of property between spouses. However, individuals undergoing divorce should consult their CPA or tax adviser before finalizing their divorce settlements. In addition to providing tax advice regarding proposed property settlements, CPAs can provide valuable assistance to both parties' attorneys in structuring such agreements.
Employee retirement plans are often a taxpayer's biggest asset and must be considered in planning for an equitable distribution of property. As part of a property settlement, there is no recognized gain or loss on a transfer of property between spouses. However, individuals undergoing divorce should consult their CPA or tax adviser before finalizing their divorce settlements. In addition to providing tax advice regarding proposed property settlements, CPAs can provide valuable assistance to both parties' attorneys in structuring such agreements.
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