QDRO Corner: The Only Certainties are Death and Taxes

Many of our clients tend to skim over the details of their agreements, instead focusing on the big items, such as how much will a retirement equalization amount be, but they ignore the details of how the funds will actually be transferred.  

1.    A Domestic Relations Order is Needed

Yes, many attorneys still forget to tell their clients that a QDRO (or similar order) is usually needed to transfer retirement assets after the divorce is final, or fails to explain the consequences of delaying.  As this firm states regularly, the best practice is to draft the order with the Agreement, and submit it to the court at the divorce hearing, or submit it as soon as possible after receiving the final order from a trial. If a client prefers to wait for any reason, be sure they are advised of the potential issues related thereto. 

The biggest issue if a party decides to wait on the QDRO is the death of the account holder before the QDRO transfer occurs. After a divorce, the account holder can change the beneficiary for their retirement accounts without consent from the former spouse. A retirement plan will appropriately pay the beneficiary(ies) listed upon being notified of their participant’s death. Once the funds leave the plan’s control and are sent to the beneficiary(ies) a QDRO is not helpful. The former spouse’s only option at that point is to sue the beneficiary(ies) for the funds. That is a less-than-ideal scenario for everyone involved.

Alternatively, the plan participant may not want to share their retirement assets with their former spouse and may move them to other accounts, or even cash them out to make the funds harder to find. In the case where the funds are simply moved to another retirement account, a QDRO can still be used. The problem is that information from the new account would have to be obtained. If the funds were withdrawn, then the former spouse has to chase through the participant’s finances and likely determine the post-tax equivalent they should receive. And, if the participant didn’t want to share the asset to start, the passage of time will not likely change their mind and make them suddenly cooperative. Many former spouses in this situation end up spending lots of money on attorneys’ fees to figure out what happened, and then figure out an alternative method to be made whole.

2.    Tax

Most agreements will describe the retirement equalization transfer as being “tax-free” because it is incident to divorce. As attorneys, it is our job to instruct clients that the transfer is “tax-free” to the spouse who owns the account from which the funds will be taken so long as the funds leave the account due to a QDRO (or similar order).

The transfer is also “tax-free” to the spouse receiving the funds if the funds are rolled over into an eligible retirement account. The spouse receiving the funds should be made aware that when the spouse takes the funds out of the retirement account, the spouse will then be taxed on the funds as if they had been that spouse’s funds all along. In addition, if the spouse receiving the funds takes the funds as cash, instead of rolling them into an eligible retirement account, then the funds will be taxed.

The “tax-free” transfer language is not a means to exempt the funds being transferred from being taxed ever, instead, it is simply notice that so long as the funds are transferred from one retirement account to another that at the time of the transfer no taxes will be paid, and particularly that however the former spouse decides to receive the funds, the participant will not suffer any tax consequences.

Ultimately how the former spouse wants to receive the funds is up to the former spouse (unless they have agreed to something specific in the settlement agreement). Whether they want to roll the funds over to a retirement account or take some or all of the funds as cash is a question they may want to discuss with a tax professional or financial planner so they can have a better idea of the tax implications they may be facing.

While some cases may have special circumstances in which the delay of a QDRO is the best practice, those situations from our experience are quite rare.  If that is the case, then language protecting the former spouse’s interest and outlining the next steps and timing should be clearly explained in the agreement.

Contact our office at 240-396-4373 if you need assistance with your QDRO.

Note: While the bulk of this article is specific to ERISA-covered plans such as 401k, 403b, etc., the same logic applies to retirement plans not covered by ERISA such as IRAs. The method of the transfer may be different, however.