What is it?

To what extent are retirement assets subject to probate and family court jurisdiction?

A retirement plan is a form of property. Like a house, cars, and bank accounts, it can be divided between spouses at the time of a divorce. If a husband, for example, participates in a pension plan at work while his wife stays home to care for the children, a judge has numerous options with respect to the retirement plan. Among other choices, he or she can award the entire pension to the husband, award all of it to the wife, or divide it between the parties. Judges often use qualified domestic relations orders (QDROs) to effect these pension assignments. In a marriage of long duration, a pension plan may be one of the most valuable marital assets.

How are retirement plans classified?

Many different kinds of retirement plans exist, with individual retirement accounts (IRAs) being one of the more common forms. In terms of employer-sponsored retirement plans, plans are classified as either qualified or nonqualified. Qualified plans are those that satisfy federal requirements and are afforded special tax treatment. Most qualified plans can be further categorized as either defined contribution plans or defined benefit plans.

• Defined contribution plans: Each participant in a defined contribution plan has an individual account. When you retire, you're entitled to receive what's in your account (no more and no less). Funding depends on the type of plan, and numerous possibilities exist for contributing. With some plans, the employees alone contribute. With other plans, the plan is either funded entirely by the employer, or funded by both employer and employees. Common examples of defined contribution plans include 401(k) plans and profit-sharing plans. For more information, see Defined Contribution Plan.
• Defined benefit plans: A traditional defined benefit plan does not use individual accounts. Instead, benefits for the participants in the plan are fixed under a particular formula. Specified benefits are paid to participants, based on such factors as age, length of service, and amount of compensation. Using these factors, most plans promise to pay the employee a certain amount per month upon retirement. Contributions to the plan are calculated by actuaries as the amounts needed to fund the promised benefits. For more information, see Defined Benefit Plan.

Before you think about dividing pension plans, it's important to grasp the difference between defined contribution plans and defined benefit plans. For more information, see Saving for Your Retirement.

What is a qualified domestic relations order (QDRO) and what requirements must it satisfy?

A QDRO is a court judgment, decree, or order establishing the marital property rights of a spouse, former spouse, child, or dependent of a pension plan participant. Specifically, a QDRO:

1. 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, and
2. Creates or recognizes the existence of the right of the individual named in item 1 (i.e., the alternate payee) to receive all or a portion of a participant's benefits under a qualified retirement plan

A QDRO must satisfy certain requirements. It must clearly specify:

• 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 that the plan must pay to each alternate payee (or the manner in which an 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

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

• Mandate increased benefits
• Pay benefits to an alternate payee that must already be paid to a different alternate payee under another QDRO
• Provide a type or form of benefit (or any option) not otherwise provided under the plan

For example, the QDRO can't require the plan to provide cost-of-living increases if the plan doesn't already have cost-of-living provisions. Furthermore, a husband's plan can't allocate 60 percent of his benefits to his ex-wife if 50 percent of the benefits had previously been allocated to a prior spouse.

In what ways may retirement plans be divided pursuant to a QDRO?

The QDRO specifies what the plan administrator does with the spouse's share of the plan. But, if under the plan a participant has no right to an immediate cash payment, then a QDRO can't require the plan administrator to make an immediate cash payment to the spouse. Instead, a QDRO is generally used to segregate plan assets into a subtrust for the benefit of the alternate payee-spouse, with cash distributions made at the earliest time they would be permitted under plan provisions.

Defined contribution plans are easy to value (since the money is sitting in an individual account), and the plan administrator usually provides a quarterly report of the value. Defined benefit plans can pose a problem and often require the services of an actuary to ascertain the present value. This can be particularly true when your eventual pension payout is tied to your compensation during your three highest paid years.

Example(s):         John is 50 years old and has a defined benefit plan that has no cash value right now. When John retires, he currently expects to receive $1,200 per month. His ex-wife, Jill, will get a portion of the payout. If there is a 50/50 split of the present value according to a QDRO, John and Jill will each get $600 per month at retirement time. However, if John actually receives $1,800 per month when he retires, Jill will still only get $600 per month.

In general, the following QDRO options are available:

• Segregation of plan assets: Segregate the alternate payee's portion of the plan until the employee reaches retirement age. At that time, the alternate payee can access the funds. With this approach, the alternate payee is treated as a participant in the plan. The employee's defined contribution plan balance (or defined benefit plan accrued benefit) is valued as of a certain date, and that benefit is divided between the participant and the alternate payee in accordance with the QDRO. Once divided, the alternate payee is treated similarly to a terminated participant with a vested deferred benefit. There are certain advantages to this approach. For example, if you're the alternate payee, you're probably assured of receiving some retirement income in the future. Also, you won't have to deal with the problems of how to invest your money right now and how to value the plan today. On the downside, staying in the plan maintains your economic ties to your ex-spouse, so you might lose some money if your ex-spouse takes early retirement. Also, you will not be able to control the investment decisions for your share of the retirement assets. Finally, your share of the plan will generally not be accessible to you until your ex-spouse reaches retirement age.
• Current distribution of plan assets: If the plan allows, the plan administrator can distribute (to the alternate payee) the full amount of money due. The alternate payee can then either keep the money and pay tax on it now, or roll it into an IRA or other plan within 60 days, thus delaying taxation. The best approach depends on the particular circumstances. For example, if you need cash now to fund expenses, you may want to keep all of the distribution. You're also able to control investment decisions. However, several potential drawbacks exist. First, there are tax problems if you don't roll the money into an IRA or qualified retirement plan within 60 days (the IRS can waive this 60-day rule under certain circumstances, such as proven hardship). Also, requesting a current distribution requires you to make your own investment decisions. Finally, you'll lose the long-term tax deferral advantage (as well as the retirement savings themselves) if you spend the money currently. For more information, see IRA and Retirement Plan Distributions.

Aside from QDROs, what options may spouses consider with respect to retirement plan assets?

One option is to trade retirement assets for something else. For example, a divorcing couple can simply decide that one spouse gets the entire retirement plan and the other gets the house, plus alimony. Alternatively, the other spouse receives a big cash buyout right now, instead of a claim on the pension assets. For more information about trading assets, see Property Settlement.

There are advantages to avoiding QDROs. You save time and money by not having to draft a QDRO. QDROs can be very expensive, especially when actuaries must be hired. Trading assets can simplify the property settlement considerably, which saves attorney's fees. Also, you may be able to trade for an asset you really want, like the house. In terms of disadvantages, you may jeopardize your future financial security if you relinquish pension rights today. Also, you and your spouse may not have enough other assets to make a fair division if your spouse keeps the entire retirement plan. In addition, if the retirement plan is a defined benefit plan, it will have to be valued in order to determine what amount of other assets would make an equitable offset.

Tip:           QDROs don't apply to most nonqualified retirement plans, such as certain annuity plans and deferred compensation plans. So, if your spouse's plan is nonqualified, the specific QDRO rules don't have to be followed.

Tip:           QDRO rules don't apply to IRAs. Nevertheless, it's possible for a QDRO to require a distribution of pension benefits to an employee, and then a transfer of the distribution to an IRA for the benefit of the former spouse.

When retirement plans are divided pursuant to a court order, what are the income tax ramifications?

• Tax impact of QDRO on plan participant: If a QDRO orders a distribution of funds from a participant's plan to a spouse or former spouse, those funds will not represent taxable income to the plan participant. The 10 percent early withdrawal penalty will not apply. However, if the alternate payee is a child or dependent (rather than a spouse), the distribution will be taxed to the plan participant. In such a case, the 10 percent early withdrawal penalty will not apply.
• Tax impact on plan participant if there is no QDRO: If there is no QDRO and retirement plan assets are distributed to a spouse (or anyone else), the distribution will be taxed to the plan participant. Furthermore, the 10 percent early withdrawal penalty may apply. Also, beware of withholding requirements. For more information, see IRA and Retirement Plan Distributions.
• Tax impact of QDRO on former spouse (or alternate payee): A spouse or former spouse who receives a distribution under a QDRO steps into the shoes of the plan participant. Thus, such distributions become taxable to the spouse rather than to the plan participant. The money will be included in the alternate payee's gross income in the year of distribution. However, any cost basis that the participant had in the plan must be apportioned. It will 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 with respect to the plan participant. If the alternate payee is the spouse or former spouse, the taxable part of any distribution received by such person will qualify as an eligible rollover distribution. Thus, it can be rolled over to an IRA or other plan. If the alternate payee is a child or other dependent, the money may not be rolled over to the IRA.

Example(s):         Assume Donald was married to Helen and had a vested balance in his 401(k) plan of $300,000. Donald had made after-tax contributions to the plan in the amount of $30,000. Donald and Helen negotiated a divorce and a QDRO was approved. Pursuant to the QDRO, Helen would get 50 percent of the plan assets immediately ($150,000). Donald's $30,000 after-tax basis in the plan will be allocated to him and Helen based on the ratio of their respective interests in the plan. Thus, $15,000 of the $150,000 distribution to Helen will be nontaxable. The remaining $135,000 will be taxable to Helen, unless she rolls this money over to an IRA or other plan within 60 days after receipt (subject to certain exceptions, as indicated above). Since the distribution was made pursuant to a QDRO, there will be no 10 percent early withdrawal penalty.

• Tax impact on former spouse if there is no QDRO: If there is no QDRO, the former spouse doesn't include the distribution in gross income. The distribution is taxable to the plan participant. Also, the plan participant may be subject to the 10 percent early withdrawal penalty. Such a distribution doesn't qualify to be rolled over to an IRA or other plan.

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