Removing funds from retirement accounts can incur hefty penalties. A QDRO can help avoid this.
Unlike dividing checking or savings accounts, dividing retirement accounts in a divorce can present some special challenges. This is because of the numerous rules that govern how money can be distributed from retirement accounts like 401(k)’s or IRA’s. This article will help you understand some of the issues involved in dealing with retirement accounts in divorce.
Penalties and taxes
There are two primary concerns when talking about taking distributions from a retirement account. The first is a 10% additional income tax (a penalty, really) on early withdrawals made before age 59 1/2. However, there are various exceptions that may allow withdrawals to be made before this age without a penalty. The second issue for clients to consider is other tax that may be due, apart from whether there is any penalty.
Avoiding the penalties by using a QDRO
Probably the most common way of avoiding the early withdrawal penalty in a divorce is to use a Qualified Domestic Relations Order (“QDRO” – pronounced kwah-droh).Tax rules provide that if a distribution from a spouse’s qualified retirement plan, (e.g. 401(k)) is made to the other spouse via a QDRO (Qualified Domestic Relations Order), then the distribution would not be subject to the 10% penalty. Specifically, Internal Revenue Code Section 72(t) allows the penalty to be avoided if:
1. The person receiving the distribution is not the titled “owner” of the plan. The recipient of the distribution must be the non-owner, or “alternate payee.”
2. Further, the plan has to be a qualified plan that is governed by ERISA. Many employer sponsored retirement plans such as 401(k) plans or 403(b) plans qualify under this definition. However, it is important to realize that Individual Retirement Accounts (IRAs) do not.
3. A QDRO must be used to divide the plan and make the distribution.
There are some retirement plans, like military pensions or government pensions (like FERS) that use court orders similar to a QDRO, but not technically called a QDRO. For example, court orders that divide FERS plans are called Court Orders Acceptable for Processing (or COAPs). This is because these plans are governed by a different set of regulations, apart from ERISA. However you may still hear some refer to these kinds of orders as QDRO because the term “QDRO” is often used as a generic term to describe any order that divides a retirement account (much in the same way ‘Kleenex’ can be used as a generic term to describe any brand of tissue).
The Mechanics of the QDRO Process
The Divorce Court enters the QDRO
The QDRO is an order that is entered in the divorce case. It is often a separate order from the Final Decree. However, in some cases, the language of the Final Decree is sufficient to be considered a ‘QDRO.’ Typically the terms of the distribution will be spelled out in the Final Decree of Divorce and/or Property Settlement Agreement, so the QDRO is essentially just a recitation of those terms.
Generally speaking, the attorney for each side will sign the QDRO and submit it to the Court for entry. In most courts in Northern Virginia, once a QDRO is submitted, it can take generally about two to three weeks for the court to return certified copies of the QDRO, signed by a judge.
The Entered QDRO is sent to the Plan Administrator
Once the judge in the divorce case signs the QDRO, the QDRO will be sent to the administrator of the retirement plan. At this point, the administrator will review the QDRO to determine if it complies with the applicable rules. ERISA allows the administrator a “reasonable” period of time in which to do this. In most cases, this process can take anywhere from 3-6 weeks.
If the QDRO is approved by the plan administrator, then the retirement plan will make arrangements for distributing the funds to the alternate payee. Typically the alternate payee may choose to roll the funds he or she receives over into a new retirement account (like an IRA), or the alternate payee can choose to receive the funds directly. It is important to note that if the alternate payee does choose to receive the funds directly (and not in a rollover to another retirement account), he or she will not have to pay the early withdrawal penalty, but other taxes may be due on the distribution.