QDRO - Tax Strategy to Avoid Retirement Plan Penalties In A Divorce
A qualified domestic relations order (QDRO) is a domestic relations order issued by a state authority - usually a court - which creates or recognizes the right of an alternate payee to receive benefits that would ordinarily belong to the participant under a retirement plan. This order must be created pursuant to the domestic relations law of the state.
When you have a retirement plan account, the right to the distribution of benefits belongs to you, the participant. You may designate beneficiaries but normally, if you receive early distributions, you may be subject to income tax and an early distribution penalty unless you qualify for certain exclusions.
In the case of a divorce, the former spouse (alternate payee) may be entitled to share in the existing value of the retirement account or it may be part of the divorce settlement agreement and therefore, it may be necessary to remove funds from the retirement plan or plans. To avoid the tax consequences and penalty in this situation, Congress has provided a scheme of tax law under the Internal Revenue Code and ERISA to support the distribution of retirement benefits to a former spouse or dependent so that the penalty is eliminated and the tax may be avoided.
To meet the QDRO requirements, the order must contain certain provisions which clearly state the names and addresses of the participant and each alternate payee, the name of each plan to which it applies, the exact amount or percentage of the benefit(s) to be paid, and the number of payments or the payment period to which the order applies.
Using a QDRO is an effective strategy to avoid the early withdrawal penalties associated with qualified retirement plans and to potentially eliminate the taxable event. To avoid the penalty, you must meet the requirements of 26 USC 414(p) and associated regulations. Failure to meet these requirements can result in a penalty assessed against the payee, even if the payee does not receive any of the distribution.
The alternate payee may have a tax consequence upon distribution but would not be liable for an early withdrawal penalty if the QDRO is properly drafted. To avoid the tax consequence, the alternate payee may roll over the distribution into another IRA account but this must be stipulated in the QDRO agreement.
It is not the responsibility of the judge who issues the order to ensure that the QDRO meets the requirements. In other words, just because a judge signs the QDRO order, it does not mean it is a valid QDRO order. It is therefore essential to have the order drafted by an attorney who is knowledgeable about the requirements and the types of provisions which would violate the QDRO requirements.