Decisions Affecting Divorce - Splitting of Retirement Benefits
Submitted November, 2000
Contents
QDRO disaster or blessing? The answer is whichever you want
it to be. A recent 10th Circuit Court reversal of the 1994 Hawkins Tax
Court decision, while being favorable to the taxpayer, emphasizes the
importance of a properly drafted Qualified Domestic Relations Order (QDRO)
to divide retirement plan assets in a divorce. The requirements of the Internal
Revenue Code, while necessary, are not difficult to meet and can save your
clients tax dollars or future legal fees.
What is a QDRO?
A QDRO is a legal document or a provision included in another legal document
such as a divorce-related property settlement or divorce decree. The QDRO
establishes the right of a former spouse (also known as the alternate payee)
to receive all or part of the other former spouse's qualified retirement plan
benefits and pay the income taxes on those benefits. In other words, "he
who gets, pays."
A QDRO is required to meet specific requirements set forth in Internal Revenue
Code Section 414(d). Until the Hawkins decision the Internal Revenue
Service had been successful in claiming that a failure to follow the statutory
requirements to the letter resulted in the participant former spouse being
taxed on a constructive distribution from the plan, which is than deemed given
to the alternate payee. In other words, the alternate payee gets the cash,
while the former spouse gets the tax liability.
Technical Requirements for QDRO's
Per Internal Revenue Code Section 414(p), a QDRO must meet all of
the following requirements.
-
It must provide for child support, alimony payments or marital property
rights for a spouse, former spouse, child or other dependent of a qualified
plan participant and it must be made pursuant to a state domestic relations
law including a community property law.
-
It must create or recognize the existence of the right of the alternate
payee to receive all or a portion of a participant's benefits under a qualified
retirement plan.
- It must specify the following:
- 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 to be
paid by the plan to each to each alternative payee (or the manner
in which the 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.
- To be a QDRO, an order must not:
- Require the plan to pay increased benefits;
- Require the plan to pay benefits to a "new" alternate
payee when a previously named alternate payee is already entitled
to those benefits; or
- Require the plan to provide a type or form of benefit or any
option that is not otherwise provided for by the plan. However
Internal Revenue Code Section 414(p)(4) does provide an exception
that permits a QDRO to require the payment of "early retirement
benefits" to a alternate payee even when the plan participant
is not entitled to such benefits.
Tax Results When a QDRO is Properly Executed
The tax outcome of using a QDRO is what the divorcing couple would expect.
The alternate payee is taxed on the funds when the funds are withdrawn from
the retirement plan account, but the 10 percent early distribution penalty
tax doesn't apply [Internal Revenue Code Section 72(f)(2)(C)]. Alternatively,
the distribution can be rolled over into an Individual Retirement Account
(IRA) owned by the alternate payee without incurring income tax, if the alternate
payee is the spouse or former spouse rather than child or other dependent
of the participant. However, the rollover must be done within 60 days of the
alternate payee's receipt of the QDRO distribution from the qualified plan.
To avoid the 20 percent federal income tax withholding that will be taken
out of a QDRO distribution, you should have the transfer made directly to
the trustee of the IRA from the trustee of the qualified plan.
Tax Results Without a QDRO --- The Hawkins Case
The disastrous tax effects of not using a QDRO to split up qualified retirement
plan benefits are illustrated by the original
Hawkins decision. Arthur
Hawkins was an orthodontist in New Mexico. Under the divorce settlement agreement,
Arthur's former spouse was awarded $1,000,000 to be paid from his qualified
retirement plan Arthur was the plan administrator and sole trustee.The Internal Revenue Service claimed the QDRO requirements were not met.
According to the Internal Revenue Service, the settlement agreement did not
establish the wife's right to plan benefits with the meaning of Internal Revenue
Code Section 414(p) because it did not specifically use the term "alternate
Payee." In addition, the former spouse's last known address was not sent
forth in the document. The Tax Court agreed with the Internal Revenue Service
that the $1,000,000 payment to Mrs. Hawkins should be treated as a distribution
to Arthur. The resulting tax deficiency to Arthur was $384,792, even though
he got none of the money.To no one's surprise, Arthur appealed to the 10
th Circuit. At
that level he won. The Appeals Court determined that the former spouse's legal
right to qualified plan benefits was clearly defined in the settlement agreement;
the amount of $1,000,000 was specified and was ordered to be paid immediately.
Since Arthur was the plan administrator and the former spouse stipulated that
he did not have her last known address, the alternate payee name and address
requirement was deemed satisfied. Therefore, the language in the settlement
agreement was sufficient to establish a QDRO.While things turned out to Arthur's advantage in the end, it took years of
expensive litigation to get there. Therefore the moral of this story is not
"it's better to be lucky than good." The real moral is: Make sure
the QDRO requirements are undisputedly fulfilled in the first place.
QDRO for IRA Funds?
QDRO's are not needed to transfer IRAs from one spouse to another spouse.
Funds from one spouse's IRA can be rolled over tax-free into an IRA set up
by the other spouse as long as the settlement agreement specifies it. To be
safe, the settlement agreement should clearly specify that the transfer of
IRA funds is required as part of the property settlement that is intended
to be tax-free under Internal Revenue Code Section 408(d)(6).Again, the best way to achieve this is through a trustee-to-trustee transfer.
However should the former spouse choose to withdraw the funds prior to age
59-1/2, he or she may be subject to a 10 percent early withdrawal penalty
in addition to income tax.What if a spouse rolls over some or all of his or her IRA funds into the
other's IRA in anticipation of a divorce? This is treated as a distribution
to the spouse who owns the IRA. This results in one party getting the money
and the other paying the tax.
Proper Planning Avoids Disasters
While most of you family law attorneys and family law judges are familiar
with QDROs and why they exist, you must insert the specific guidelines provided
for in Internal Revenue Code Section 414(p) to avoid Internal Revenue Service
challenge. While failure to precisely follow Section 414(p) guidelines may
not ultimately be fatal, as the 10
th Circuit's decision in
Hawkins indicates, the client may have to litigate to gain the desired tax outcome.
It is much better for you to get involved on the front end in drafting "airtight"
QDRO language for your client and also making sure IRA funds are transferred
properly.
Copyright © 2000
Clifton
G. Lamb, Jr., CPA. All rights reserved. No portion of this article may
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