QDROS for 401(k), 403(b) and 457 Plans
The two most common types of retirement plans are defined benefit plans and defined contribution plans. Defined contribution plans have an account balance, such as 401(k), 403(b) and 457 plans. Defined benefit plans are commonly known as pension plans and pay a monthly benefit in the future with the amount payable determined at the time of retirement.
This blog will briefly discuss the most common issues involved with dividing defined contributions plans due to divorce. These issues are: defining the community property interest, determining how the plan will treat investment gains and losses on the alternate payee’s portion, and deciding how to treat outstanding loans.
DIVISION OF COMMUNITY PROPERTY INTEREST
Parties to a divorce can agree to transfer any percentage or dollar amount to the non-employee spouse (a.k.a. the “Alternate Payee”). Often, funds from 401(k), 403(b) or 457 plans are used to equalize other marital assets during divorce. However, the most common division is the community interest division. This means that the Alternate Payee will receive one-half of the contributions from the date of marriage through the date of separation. Usually, the plan administrator can calculate this amount; however, in some situations the record keeper for the plan will not have records that date back to the date of marriage. If the record keeper does not have adequate records, then this information will need to be supplied by the parties via old plan statements, or the parties can hire an actuary or accountant to estimate the community property interest, and then can stipulate to the amount to be transferred.
GAINS & LOSSES
Typically, gains and losses (or “earnings”) attributable to the amount assigned to the Alternate Payee are also applied to the amount. However, the parties can come to an agreement where earnings are not awarded on the Alternate Payee’s share. If the parties determine a flat dollar amount to be assigned to the Alternate Payee, gains and losses are usually not included. Gains and losses can make a significant difference in the amount of the benefit awarded to the Alternate Payee, so this issue should be considered seriously by the parties.
Another important issue is the treatment of any loans that are outstanding with the plan as of the date of account division. When a percentage of the account is assigned to the Alternate Payee, including an outstanding loan in the account balance, i.e. adding the amount of the loan back in, will result in a larger portion for the Alternate Payee. Subtracting the outstanding loan from the account balance will reduce the amount paid to the Alternate Payee. Usually, the parties will evaluate when the loan was taken out by the Plan Participant and what the funds were used for to determine if the loan should be considered a community loan (included in the account) or the Participant’s own loan (excluded for the purposes of calculation). It is important to know that loans from retirement plans are not assignable, the Participant must pay the loan back even if loans are included for purposes of division. This also means that if 100% of a plan is being assigned to the Alternate Payee, there must not be any plan loans. If there are any outstanding plan loans, then an amount sufficient to cover the loan must be left in the account.
TIMING & TAX ISSUES
Parties should also be aware of timing and taxation issues for defined contribution plan QDROs. Plans will usually allow an immediate distribution to an Alternate Payee. The Alternate Payee may roll the assigned amount to an IRA, take it in cash, or do some combination of IRA rollover and cash distribution, subject to the terms of the plan. If the Alternate Payee is allowed to leave the funds in the plan, the funds usually cannot be accessed without penalty until he/she reaches age 59 ½.
Regarding the taxation of benefits upon distribution, Alternate Payees are responsible for the income taxes on any distributions made to them pursuant to a QDRO. The distribution from the plan is taxable to the participant for distributions made for child support or distributions made without a QDRO. The plan will withhold 20% of any immediate cash distribution for federal income tax, but there is no 10% excise tax when an alternate payee takes a distribution from a qualified plan pursuant to a QDRO. This can help an alternate payee who needs cash before they turn age 59 ½.
Almost all defined contribution plans are divisible by QDRO. The parties’ judgment, divorce decree or marital settlement agreement should address the issues listed above since the QDRO should reflect the judgment and having a written agreement prior to drafting a QDRO will allow for the QDRO process to run more smoothly and efficiently.
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