Tax benefits of using a QDRO

A divorce can have many tax implications and some of these arise when splitting retirement accounts.

It is common for couples getting divorced in Massachusetts to divide their joint assets and liabilities. This is a normal part of the property division process in most divorces today. Among the items that can be identified as marital property are homes, other property, boats, vehicles and intangible assets such as bank accounts and retirement accounts.

Perhaps one of the biggest concerns when it comes to splitting 401K or other such assets is taxation. Retirement accounts can also be tapped into for making spousal support payments. These types of funds can be subject to very high taxes if the right processes are not utilized.

A real-life example

Forbes provided information about a final divorce settlement that indicated the husband should make his spousal support payment using money from his 401K account. As ordered by the family court judge, the man did just that. The amount was close to $53,000.

People may believe that because this act was taken under the direction of the court, that no penalties or taxes would be assessed on this non-retirement distribution from a retirement account. However, that is wrong. The husband was assessed taxes for 10 percent of the amount by the Internal Revenue Service as the distribution was viewed as an early withdrawal. This is because the man did not meet retirement criteria nor did he utilize a Qualified Domestic Relations Order.

How can a QDRO help?

To understand how a QDRO can help, one must understand really what it is. The U.S. Department of Labor offers some information about this. Simply put, a Qualified Domestic Relations Order is a legal way of identifying additional payees for specific retirement funds. In the case noted above, a QDRO would essentially delineate the ex-wife as an alternate payee and thereby have eliminated the taxation on the husband.

According to the website for the Internal Revenue Service indicates that a QDRO can be utilized when identifying payments for child support, spousal support and the splitting of retirement accounts in domestic matters. One stipulation however is that only former spouses or dependents can be alternate payees under a QDRO. Retirement account distributions that are pursuant to a property division agreement will not result in any taxes being assessed so long as the received funds are put into another qualifying retirement account.

Beware the details

A Qualified Domestic Relations Order must be set up properly. Details about the alternate payee must be complete as should be any information identifying the amount or percent of the plan's value to be distributed. If multiple payments are to be made, the payment dates and number of payments should be clearly communicated as well.

It is also important to note that a QDRO is to be used only for 401K and 403B accounts. Other types of retirement accounts, such as IRAs, make use of different means of identifying alternate payees or splitting values.

Getting help matters

Being hit with an unexpected tax bill is never fun. Making sure that you work with a qualified professional from the outset of your divorce is important and can help to minimize these situations.

Keywords: divorce, assets, property, retirement