QDRO Tax Issues
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!
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