401(k) and Divorce

You have saved and invested for the long term in your 401(k) plan, accumulating a sizable nest egg. But what happens if you become divorced? In a divorce, your former spouse and any dependents may be entitled to a portion of you 401(k) assets. If this is the case, the court will issue a qualified domestic relations order (QDRO) as part of your divorce settlement that will define the what, when, and how of the division of your 401(k) or other retirement plan account.

A QDRO is a court judgement, decree, or order that names someone other than you as a recipient of you 401(k) assets. This other person, known as the alternate payee, may only be your spouse, your former spouse, your child, or other dependent. The QDRO is used in the division of assets in a divorce settlement for alimony payments, child support payments, or property rights payments. If you are involved in a divorce proceeding, be sure to ask your company’s plan administrator if there is a model QDRO form for your plan. Doing so early on in the process will save you time and expense.

There is one piece of good news in this situation. The money removed from your account for a properly processed QDRO is not subject to the 10 percent early withdrawal federal income tax penalty-even if you and your alternate payee are both younger that age 59 ½. Unfortunately, if the QDRO is not properly established, you will be subject to the 10 percent early withdrawal federal income tax penalty. In the midst of divorce and the distribution of your account to other parties, the last thing you want to face is a tax on money that is no longer yours.

Ensuring the Validity of a QDRO

In order for a QDRO to be valid, it must meet two legal requirements: It must be correctly created and it must be correctly verified. Checking the status of your QDRO at both stages is wise to ensure that your QDRO is acceptable under the law. If this seems like a lot of trouble, keep in mind that aside from preventing undo taxation, the other reason why such checking and double-checking takes place is to prevent someone from illegally accessing your 401(k) assets.

Creation of the QDRO

To be considered a QDRO, the division of your assets must first and foremost be directed by a court order issued in compliance with state laws. However, the QDRO must also include the following information to be valid:

  • Your name and your last known mailing address.
  • The name and address of your alternate payee.
  • The amount of percentage of your account to be given to your alternate payee.
  • The manner in which the amount or percentage is to be determined.
  • The number of payments or period to which the order applies.
  • The plan to which the order applies.

Verification of the QDRO

If your 401(k) plan assets are subject to a QDRO, you must provide your plan administrator with either the original court order or a court-certified copy of your QDRO document. Your plan administrator will then follow formal procedures to establish the legality of the QDRO and put it into motion. These procedures are part of the rules set down in your 401(k) summary plan description (SPD), and by law they must include:

  • Notifying you and the alternate payee that the order was received, and detailing the procedures that will be followed to verify the order.
  • Determining within a reasonable period of time (no longer than 18 months after the order is issued) whether the order is valid QDRO.
  • Accounting separately for any amount payable to your alternate payee during the evaluation period.
  • Notifying you and your alternate payee whether the QDRO is valid.

A QDRO Case Study

In a famous case, a man paid out $1 millions dollars from his retirement plan as part of his divorce settlement. The man assumed that the order was a QDRO, but missed several key elements that caused the order to be invalid. First, the man’s former wife was not identified as the alternate payee. Second, the order did not include the name or address of the alternate payee. Third, the man did not follow proper procedure for verifying the order.

Because the man was the administrator of the retirement plan in question, he argued that he did not need to file forms with himself, and that the order did not need to include the name and address of the alternate payee because he was personally aware of the details. The IRS did not agree, and deemed the settlement payment an early distribution and, therefore, subject to the 10 percent early withdrawal federal income tax penalty. This error cost him $100,000.

The Division of Funds in a Divorce

How your funds are divided relies in part on the state in which you live. In most states, your assets are subject to equitable distribution during a divorce settlement. This means that 401(k) assets accumulated during your marriage probably, but not necessarily, will be divided 50-50. Other factors, such as the division of the rest of your marital assets, the length of your marriage, or what each of you contributed to the marriage will also play a part in the decision. However, if you live in a state with a community property law, you may face an equal split in your 401(k) assets regardless of the other division of marital assets. Following is a list of states that include the community property law:

  • Arizona
  • California
  • Idaho
  • Louisiana
  • Nevada
  • New Mexico
  • Texas
  • Washington
  • Wisconsin

What to Do with QDRO Assets

If you have recently gone through a divorce and will receive money from your former spouse’s 401(k) plan a result of a QDRO, you have several options. Taking the money in cash can be useful to get through the rough divorce period, but keeping the assets within a tax-sheltered plan could be far more beneficial. If you receive a lump-sum distribution you will have to pay taxes on the entire amount immediately and you will lose the investing and earning power of that money for the future.

Instead, consider leaving the money in your former spouse’s 401(k) plan or rolling it over into an IRA. If you would like to leave it in the 401(k) plan, you can make this stipulation part of the QDRO agreement. When the money is divided, the plan’s administrator will create a separate account for you. You may not be able to add to this account or withdraw from it until your former spouse withdraws his or her money at retirement, but you will be able to mange the investments of this money yourself and keep it safely tax-sheltered. If you would instead prefer an account to which you can make contributions, rolling the money into an IRA is the best option. Rolling the money into an account not connected with your former spouse also provides you with more freedom as you are allowed to withdraw the money at your own discretion.