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Dividing up retirement accounts in a divorce isn't as simple as withdrawing half of your balance and handing it over to your ex. Your employer's plan administrator may not allow early withdrawals. And if they do, the IRS would likely tax and penalize you for taking an early, unqualified distribution.
You can split assets in an employer-sponsored retirement plan like a 401(k) or 457 with the help of a qualified domestic relations order (QDRO, pronounced "quadro"). This often-overlooked but important document officially transfers one spouse's retirement assets to the other spouse in a divorce. Here's how a QDRO works.
What Is a QDRO?
A QDRO is a legal document that recognizes an ex-spouse or dependents' interest in a participant's retirement plan. A QDRO may be included as part of a divorce agreement when spouses want to split retirement account assets as part of the division of marital assets.
When Do You Need a QDRO?
QDROs are used during the divorce process to divide assets in a qualified retirement plan. Any employer-based retirement plan that qualifies under the Employee Retirement Income Security Act of 1874 (ERISA)—including 401(k), 403(b) and SEP IRA plans—requires a QDRO to divide funds. You do not need a QDRO to split funds in an individual retirement account (IRA).
A QDRO may also be used to pay child or spousal support if plan rules and funds in the account support the request.
How Does a QDRO Split Assets?
The QDRO can name a dollar amount or a percentage of benefits to be paid to the plan participant's ex-spouse. The distribution can be made as a lump sum or in regular plan payments. You may also be able to designate a percentage of an account as the property of the non-participating spouse to be distributed later.
Is a QDRO Distribution Taxable?
Withdrawing money from a QDRO is a taxable distribution. Benefits paid to an ex-spouse are taxable to that person; benefits paid to a participant's children are taxed to the participant.
An ex-spouse may avoid paying taxes on a QDRO distribution by rolling funds into a qualifying retirement account, as they would roll over a regular 401(k) distribution. Funds withdrawn in a divorce settlement are typically exempt from the 10% early withdrawal penalty for retirement accounts levied by the IRS.
Why Is a QDRO Important?
A QDRO is necessary if you want to divide certain retirement assets in a divorce. Here are a few reasons a QDRO may be important:
- A QDRO is required to divide retirement plan funds. Plan administrators can't distribute funds to a non-participating ex-spouse without one. A QDRO officially informs the plan administrator that funds are being withdrawn as part of a divorce.
- A QDRO allows divorcing partners to include retirement plan assets in their settlement. This may be critical to retirement planning. Retirement savings are often among the largest assets partners have when they divorce, and both partners may not have equal or comparable assets.
- A QDRO lets you withdraw retirement funds in a divorce without incurring an IRS penalty for early withdrawal. This may be crucial for spouses trying to navigate newly separate financial lives and for whom paying a penalty could be difficult.
- Transferring retirement assets from one spouse to the other may provide them financial security. In cases where one spouse stayed home during the marriage or earned less, having access to part of their ex-spouse's retirement funds can mean the difference between struggle and a little more security in their later years.
Can You Avoid Getting a QDRO?
Splitting retirement plan assets in a divorce can be complicated; so is creating and submitting a QDRO. QDRO documents are notorious for pages of boilerplate language that can confuse the average reader.
To get around dealing with QDROs, many couples choose to split their assets without involving their 401(k)s. Say, for example, that Jo has a retirement plan with $150,000 accumulated during the marriage, and Terry has $200,000 in a separate 401(k) plan. Instead of splitting each account, Jo and Terry might keep their respective accounts intact and allocate an extra $25,000 in cash or other assets for Jo, to compensate for the $50,000 difference in account values.
Before you make a decision to pursue an exchange of marital assets in lieu of a QDRO, it may be best to consult with an attorney or tax professional.
How Do You Get a QDRO?
Drawing up a QDRO should be part of your divorce process if you're planning to split 401(k) or other employer-sponsored retirement accounts. The basic steps are as follows:
1. Define Your Terms
Work with your attorneys or a mediator to define the terms of your divorce settlement, including any division of retirement accounts. You may arrive at your own settlement agreement if you're managing your own divorce.
2. Draw up Your QDRO
You aren't legally required to work with a specialized financial advisor or divorce attorney to draft a QDRO, but getting expert help may save you time, frustration and money. QDROs are not simple to craft—and the stakes are high. If you don't draft the order correctly, the plan administrator can reject it. Making a mistake could have serious tax implications if your QDRO does not comply with IRS requirements.
Even if you're DIY-ing your divorce, getting professional help with your QDRO could be a worthy investment. Most attorneys who specialize in QDROs will charge you a small fee—much smaller than missing out on retirement funds—to draw up the paperwork.
Once your QDRO is complete and all parties have signed, a judge will sign off on it.
3. Submit Your Order to the Plan Administrator
The alternate payee (or non-participating ex-spouse) submits the QDRO to the retirement plan administrator, who carries out the order. The plan administrator has up to 18 months to respond, so you may want to start the process early, even before the divorce is final, to make sure your order is approved. If not, you may end up renegotiating your divorce settlement to accommodate plan requirements.
The Bottom Line
Between your retirement plan administrator and the IRS, you'll have plenty of detailed requirements to contend with if you need to divide retirement accounts. Although the process may be lengthy and complicated, being able to divide retirement assets cleanly can be an important step for divorcing partners.
Understanding plan requirements and IRS provisions, putting together a QDRO, submitting it and following through by rolling over funds or reporting your distribution to the IRS can be challenging. Seeking expert help from a specialized financial advisor or attorney can save you time and aggravation—and may save you money by keeping you on the right side of the IRS.