Posts tagged ‘QDRO tax’

Additional QDRO Benefits: Taxes, Liquidity, and Bankruptcy, Creditor & Tax Lien Protection

TYPICAL REASON FOR HAVING A QDRO

The most common reason for parties to have a Qualified Domestic Relations Order (QDRO) is to divide retirement benefits due to divorce or legal separation.  Most retirement plans require a QDRO, or similar court order, before benefits can be paid from the plan to an alternate payee (non-employee former spouse of the plan participant).  However, there are other benefits to QDROs that are sometimes overlooked.  For instance, the parties may consider an equalization of other assets in order to avoid the necessity of preparing a QDRO, but QDROs can provide additional benefits that other property equalizations cannot.

TAX BENEFITS OF QDROs

One of the main tax benefits of a QDRO is the exemption from the early distribution or premature withdrawal penalty.  We have previously elaborated on these tax benefits in this blog post.  For California residents, the QDRO exemption under IRC §72(t)(2)(c) will typically save approximately 12% in combined state and federal taxes on any distributions made pursuant to a QDRO prior to the alternate payee reaching age 59 ½.  QDROs can also allow for the continued tax-deferred growth of benefits after the death of the participant, which would not normally be available to a former spouse beneficiary under an IRA.

QDROs & LIQUIDITY    

Due to restrictions on distributions built into many retirement plans, the participant cannot receive any funds until reaching the plan’s earliest retirement age.  However, for some plans, QDROs will allow benefits to be distributed to an alternate payee prior to the date that such distribution would be available for the participant.  This can assist in providing the alternate payee with the necessary liquidity due to other property equalizations, such as buying out the participant’s interest in the family home.  (See IRC §414(p)(4), (9); Treas Reg §§1.401(a)-13(g), 1.409A-2-1.409A-3)

BANKRUPTCY, TAX LIEN AND CREDITOR PROTECTION UNDER QDROs

Assets held under qualified retirement plans are usually exempt from the bankruptcy estate (11 USC §522). The alternate payee’s share of the benefits can also be protected from tax liens against the participant (U.S. v Taylor (8th Cir 2003) 338 F3d 947). QDROs can also protect assets from other creditors under Cal. Civ. Proc. Code §704.115, with some exceptions, such as enforcing orders under the Mandatory Victims Restitution Act, as in U.S. v. Novack.

PREVENTING LOSS OF BENEFITS ON PARTICIPANT’S DEATH

As mentioned in our “When Should I File My QDRO?” blog, if a QDRO is not filed and a participant dies, the alternate payee may lose his/her entire interest in the retirement benefits.  For example, if a participant dies while unmarried and while still working, there may be a “Qualified Pre-Retirement Survivor Annuity” or “QPSA” available.  A QDRO could secure all or a portion of the QPSA benefits for the former spouse of the participant in such a case.  QDROs can also ensure that a former spouse will receive all or a portion of other survivor benefits paid upon the participant’s death, including those paid if the participant dies after retirement.

DO YOU NEED A QDRO?

If you have questions about the division of retirement benefits due to your California dissolution of marriage or legal separation, or if you would like to get started on your Qualified Domestic Relations Order today, please call QDRO Helper at (619) 786-QDRO / (619) 786-7376.  You can also request a new client package by sending an email to info@qdrohelper.com.  We proudly assist clients throughout the United States as long as the divorce or legal separation took place in California.

DISCLAIMER: ADVERTISEMENT. Any legal information on this blog has been prepared by QDRO Helper for informational purposes only and is not legal advice and does not constitute a guarantee, warranty, or prediction regarding the outcome of your legal matter. The information provided is intended to comply with Rule 1-400 of the California Rules of Professional Conduct. Any links in this website are included only to help you locate other Internet resources that may be of interest to you; QDRO Helper is not associated with any such links. The transmission and receipt of information contained on this website via the Internet or e-mail or in any other manner does not constitute or create an attorney-client relationship, and you should not act on the information contained herein without obtaining legal counsel. QDRO Helper has a strict policy of entering into attorney-client relationships with its clients only though the execution of a written fee agreement acknowledged by QDRO Helper. As such, you should not send QDRO Helper any confidential information in response to this web page until such a relationship is established and expressly acknowledged by QDRO Helper.

QDRO Tax Issues

Written September 12th, 2012
Categories: General QDRO Info

There are various taxation issues to consider before obtaining a QDRO to divide retirement benefits pursuant to a marital dissolution or divorce.

TYPICAL QDRO TAXATION

Generally, under a Qualified Domestic Relations Order (QDRO), an employee benefit plan or retirement plan makes direct payments to each party his or her share of benefits.  Each party is taxed on the benefits paid to him or her (as long as the parties are spouses or former spouses).  The plan will report distribution information to the IRS and issue the appropriate tax forms to the parties.   As mentioned above, only a spouse or former spouse can be treated as a “distributee” for income tax purposes.  See IRC §402(e)(1)(A).

However, if an employee (instead of the plan) is making payments to a former spouse (because there is no QDRO or because the former spouse has exercised Gillmore rights), then the plan will report all distributions as income to the employee, and the employee spouse will likely be taxed on all distributions and will not be able to take a tax deduction for payments made to a former spouse, unless the payments to the former spouse qualify for spousal support tax treatment.

TAX ON EARLY DISTRIBUTION – 10% PREMATURE WITHDRAWAL PENALTY

If an employee takes an early distribution, i.e. before age 59 ½, the distribution is taxed as ordinary income to the employee and there is an additional 10% tax penalty levied on the amount distributed. See IRC §72(t)(1).  Payments under a QDRO made to an Alternate Payee are exempt from the additional 10% penalty on early distribution pursuant to IRC §72(t)(2)(c).

TAX TREATMENT OF ROLLOVERS

Most defined contribution plan distributions to alternate payees can be rolled into an IRA or other eligible retirement plan without any income tax or withholding consequences at the time of rollover, as long as the rollover is a direct trustee-to-trustee transfer.

If a direct rollover does not occur, the alternate payee receives the funds and rolls them over within 60 days of receipt, then the amount rolled over will not be taxes as income but 20% will be automatically withheld by the IRS.  The IRS will only refund the 20% withheld after the alternate payee files a tax return for that year; further if the alternate payee does not replace the 20% withheld when making the deposit in into the IRA or other plan (i.e. only 80% of the original distribution is redeposited), then the IRS will consider the 20% withheld to be a distribution to the alternate payee and he/she will be taxed on that distribution.  As you can see, it is critical to ensure that a direct rollover occur in order to avoid penalties and taxation issues.

WHAT IF THE ALTERNATE PAYEE IS NOT THE EMPLOYEE’S SPOUSE OR FORMER SPOUSE?

A child or other dependent of a participant may be an alternate payee under a QDRO, such as a QDRO for child support, but a distribution to an individual who is not the spouse or former spouse of the retirement plan participant will be taxable to the employee-participant only, not to the alternate payee.

TAXATION ISSUES FOR REGISTERED DOMESTIC PARTNERS’ QDROS

The federal Defense of Marriage Act (DOMA) does not recognize domestic partners as spouses (or former spouses) for federal tax purposes.  As described in the previous paragraph, this means that the employee/plan participant will have to pay taxes on any distributions paid to a registered domestic partner.  In order to address this inequity, parties in the dissolution of a domestic partnership may agree to award all retirement benefits to the employee partner and to offset such award with other community property being awarded to the non-employee partner.

DO YOU HAVE QUESTIONS ABOUT QDROS & TAX?

If you have additional questions about Qualified Domestic Relations Orders and tax issues, feel free to contact our California QDRO attorneys at (619) 786-QDRO.  You can also contact QDRO Helper to get started on your QDRO today!

 

DISCLAIMER: Any legal information on this blog has been prepared by QDRO Helper for informational purposes only and should not be construed as legal advice. The material posted on this website is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Note that sending an e-mail to QDRO Helper does not create an attorney-client relationship, and none will be formed unless there is an express agreement between the firm and the individual. We strongly advise against sending confidential or privileged information to QDRO Helper until you can establish such a relationship.

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