Do I need a QDRO in my divorce?
The questions I am receiving go something like this: husband owns a 401k account and the spouses have agreed to divide the 401k account as part of the divorce. Wife wants the money before the divorce is complete and/or doesn’t want to pay for the QDRO, so she tries to convince the husband to take a distribution from the 401k and give it to her. Sounds so much easier than adding another legal process to the divorce, right? It’s a good deal for the wife because she gets to avoid paying to have the DRO (domestic relations order) drafted, gets the money quicker and gets to stick the husband with all of the tax consequences. It’s a rotten deal for the husband. When a distribution is made from a 401k account, that distribution is taxable to the account owner. The 401k plan will withhold 20% as a down payment on the federal income tax but the entire amount of the distribution is added to the husband’s taxable income for the year so not only will he pay taxes on the distribution but he will likely pay more in taxes on every dollar he makes that year. He might pay a lot more. Additionally, if the husband is under 59 1/2 years old, he will probably also pay a 10% penalty on the distribution for taking the retirement funds out early. There’s no value for the husband to pay taxes to give his wife part of his retirement account when there is a legal process that will divide the account with no tax consequences to the husband. (Obviously, roles may be reversed and the wife may own the 401k account and the husband may be the recipient of the divided portion of the account.)
That process is known as a qualified domestic relations order or QDRO. When the 401k account is divided in the divorce decree, it awards the assigned portion to the non-account owner, known as an alternate payee. The alternate payee is then responsible for preparing a domestic relations order (DRO) that the judge will sign. The DRO is an order to the 401k plan ordering the division based on the terms of the DRO, which should align with the terms of the divorce decree. The plan administrator for the 401k plan will review the DRO and determine if it meets the plan rules for dividing an acount. If the DRO meets plan rules it is qualified by the plan administrator and becomes a QDRO. The plan administrator will then divide the account and make those funds available to the alternate payee to take as cash, rolled over to another retirement account, or the plan may allow the funds to remain in the plan under the control of the alternate payee. When the alternate payee takes those funds from the 401k as cash, the alternate payee pays the income tax but does not pay a 10% penalty unless the alternate payee first rolls the funds over to another retirement account and the 10% penalty would apply to the distribution from the latter retirement account.
Under the QDRO process, the account holder benefits from paying very little, if anything, in the division. The alternate payee typically bears the cost of drafting the DRO. It is common for the plan administrator to divide the plan’s fee for dividing the account between both spouses. The alternate payee will bear all tax consequences of the distribution, unless you have foolishly agreed to pay them (which almost never happens, despite what some alternate payees believe). At most, the account holder will pay a portion of the plan’s fee for dividing the account, a process commonly called “segregation”.
Aside from the financial burden of not following the QDRO process, the 401k account holder can get himself or herself in trouble by taking money out of the plan and giving it to the other person. In some rare situations, the alternate payee attempts to double dip against the account holder. The divorce decree will call for a division of assets but rather than insisting on the QDRO, the account holder will take the money out and give it to the alternate payee. The alternate payee will take the money and then go get the DRO and insist he or she never took the money in the first place. Now, obviously, the account holder should have given the alternate payee a check and proving the check was cashed is not terribly difficult but the account holder may spend a lot of unnecessary money offering that proof. You don’t need to pay the taxes on the distribution and then have to go back to court to prove you paid the funds to your ex-spouse. I’ve seen situations where the court issued the DRO after the account holder paid cash to the alternate payee and then the plan complied with the DRO and paid out the other half of the account to the alternate payee. Don’t put yourself at risk for that situation. A QDRO is your friend.
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