Often, one of a couple’s most valuable marital assets is a retirement plan. A retirement plan may be in only one spouse’s name, but it’s a community asset subject to equal division during a divorce. When a divorce settlement agreement or court order requires one spouse to give the other a portion of their retirement savings, many spouses make the mistake of simply withdrawing that amount from their 401K, 403b, or other non-IRA retirement plan. Sadly, this mistake can cost thousands in tax penalties. Instead of withdrawing from a retirement plan, a Qualified Domestic Relations Order (QDRO) saves the divorcing spouses from this common pitfall.
What is a Qualified Domestic Relations Order?
A Qualified Domestic Relations Order is a legal document issued by a court to define a party other than the account holder as an alternate payee on the account. The QDRO then acts as a vehicle to transfer a portion of one individual’s retirement funds to someone else—typically a spouse, but sometimes a child. The QDRO can be paid out through a lump-sum payment, in installments, or by rolling the amount over into another retirement account. These domestic relations orders are often issued during a divorce at the request of the paying spouse to avoid tax penalties.
What Are the Tax Benefits of a QDRO?
When a judge orders one spouse to distribute a portion of their retirement fund to the other spouse in a divorce judgment and they simply withdraw the allotted amount, they are responsible for the following:
- Paying the amount of income taxes due after the distribution—typically 20% will be withheld for taxes
- Spouses under age 59.5 who withdraw funds also trigger an additional tax penalty of 10%
By using a QDRO to distribute the funds to an ex-spouse, the former spouse then has the burden of paying the income taxes if they receive the funds directly. Alternatively, the spouse who receives the distribution can roll the assets over into another retirement account to avoid the taxes completely.
Some spouses who receive these funds wish to keep a portion of the money to spend immediately and roll the rest into a retirement account. In this case, they’ll be responsible for paying income tax on the amount they keep to spend, but not on the amount they roll over.
A well-executed QDRO from one retirement account into another is the best option for financial security for both parties in a divorce. It makes the transfer of retirement assets a non-taxable transaction for both spouses.
Does a QDRO Have Limits?
The U.S. Department of Labor places limits and restrictions on QDROs, including the following:
- A QDRO can’t compel a retirement plan to disburse any benefit not provided by the account holder’s plan
- It cannot require increased benefits
- A QDRO can’t require a distribution for subsequent ex-spouses if funds have already been allocated for a prior ex-spouse
Whether you’re the spouse required to pay a portion of your retirement plan to an ex-spouse, or you’re the ex-spouse expecting a portion of a spouse’s retirement plan in a divorce settlement, it’s helpful to speak to an attorney about the benefits of a Qualified Domestic Relations Order.