When a couple divorces, it is often necessary to divide assets held in qualified retirement plan accounts [e.g., Section 401(k), profit-sharing, or pension plan accounts] to equitably divide the marital property. When your qualified plan assets are divided in divorce, a qualified domestic relations order (QDRO) is critical. A QDRO is any judgment, decree, or order that (a) creates or recognizes the existence of an alternate payee’s (e.g., your former spouse’s) right to some or all of the participant’s (your) qualified plan benefits; (b) is made pursuant to a state domestic relations order; and (c) relates to providing child support, alimony, or marital property rights of a spouse, former spouse, child, or other dependent of the plan participant. IRAs are not qualified plans and, therefore, not subject to the QDRO rules.
Without a QDRO, distributions from your qualified retirement plan to another person are treated as paid to that person on your behalf. Thus, you are taxed on the distribution as if you had received it and then given the cash to the other person (e.g., your former spouse). In this situation, you receive no deduction for the deemed transfer to, for example, your former spouse, and the entire distribution is taxable to you in the year received. Clearly, this is the worst possible result you might expect. However, distributions under a QDRO are taxed to the recipient (e.g., your former spouse) when received by that person. The 10% early distribution penalty tax does not apply to any distribution to an alternate payee pursuant to a QDRO, regardless of the alternate payee’s age when he or she receives it.
Generally, the alternate payee is assigned the participant’s tax attributes under the plan. If the alternate payee is your spouse or former spouse, any distribution received by that person will qualify for rollover treatment to an IRA. A properly rolled over distribution is not taxed until it is subsequently withdrawn from the IRA. To qualify for tax deferral, the distribution must be rolled into the IRA within 60 days of receipt. The funds should be transferred directly from the distributing plan to the receiving IRA (a trustee-to-trustee transfer) to avoid the 20% withholding that is imposed if a distribution is made directly to the recipient. However, the QDRO exception to the 10% early distribution penalty tax does not apply to distributions from IRAs, SEPs, and SIMPLEs.
A rollover to an IRA allows the alternate payee to control the account’s investment. It may also be attractive when the alternate payee wants to sever ties that connect him or her to the former spouse.
If the alternate payee is under age 59½, rolling over a plan distribution made under a QDRO to an IRA may not be advisable. Subsequent IRA distributions before age 59½ would generally be subject to the 10% early distribution penalty tax, unless an exception applies. If the plan allows, a better solution may be to leave the funds in a segregated account with the plan trustee. Distributions from the segregated account pursuant to the QDRO are not subject to the early distribution penalty tax even if made before age 59½.
Please contact Martini, Iosue & Akpovi by phone at (818) 789-1179 if you have questions or want more information.