Q is for QDRO
Divorce is never easy. Whether it’s amicable, contentious, or a “conscious uncoupling” a la Gwyneth Paltrow and Chris Martin, there are still issues to work out which could include support, child custody, and property distribution.
In particular, property distribution can be tricky when the assets in a marriage are held in unequal shares, are not liquid, or are not easily divisible. One of the assets that tend to touch on all three (equality, liquidity, and divisibility) is a retirement plan. Depending on the financial arrangements inside a marriage, it’s not unusual for one spouse to hold a retirement plan that constitutes a significant share of marital assets. Dividing that asset up could cause unfortunate tax consequences. Fortunately, there’s a provision in tax law that focuses on precisely this issue.
There is, however, a crucial concept to understand when thinking about the tax consequences of divorce – especially when it comes to retirement plans. More often than not, all tax provisions from alimony to asset division, are dependent on a valid judgment, decree, or order. It’s not enough to feel divorced, act divorced, or agree to be divorced. You must be actually divorced (or separated, depending on the issue and the state).
As part of your divorce settlement, you’ll likely want to seek out a QDRO, or qualified domestic relations order, to deal with the division of any retirement plan. A QDRO is not limited to asset distribution: it may also be used to satisfy an order of child or spousal support.
A QDRO is a judgment, decree, or order that assigns or retitles some or all of a retirement plan participant’s assets into another person’s name. Ordinarily, this kind of change in ownership would result in potentially negative tax consequences (for example, it could be treated as a distribution and fully taxable). But if properly drafted, a QDRO allows the former spouse the same kind of rights as if he or she had been the original participant in the plan. That would include the ability to roll over tax-free all or part of a distribution from a qualified retirement plan received under a QDRO.
It’s important to note that while a QDRO can preserve the character of a retirement plan, it does not change it. That means that actual distributions made as part of a QDRO would generally be taxed in the same manner as a regular distribution; one significant exception applies for cash payouts which are not subject to the early withdrawal penalty under a QDRO. But to be clear, a division of assets under a QDRO does not mean that the former spouse will receive a tax-free distribution from a retirement plan. The same tax attributes apply as before the transfer. Those tax consequences should be taken into consideration when determining the split at the time of the drafting of the QDRO – and not after.
In contrast to the treatment of a QDRO distribution to a former spouse, a QDRO distribution that is paid to a child or other dependent is taxed to the plan participant.
The IRS rules for QDROs are generally laid out at IRC Sec. 414(p) – but they’re not for the faint of heart. QDROs and divorce law can be complicated, so I highly recommend consulting with your tax professional when negotiating the terms of your divorce settlement.
