Divorce happens, in fact it seems to occur at an accelerated rate these days. Divorces are mentally, emotionally, and financially draining (literally). A legal separation usually involves a meticulous separation of assets, and that's where we can help. The likelihood that retirement accounts will be among the list of assets is high and may even make up a large percentage the total assets to be divided. Attorneys will more than likely be involved and you will definitely want to make sure everything is separated and executed according to plan. Let's break down your options for doing so.
Pension Plans & Employer Retirement Plans and QDROs
If you or your spouse has a pension or retirement plan provided by an employer, then you have the option to utilize a QDRO to separate the assets in the plan. This could mean splitting the account balance(s) 50/50 (or any other dollar amount/percentage), giving your ex-spouse the entire balance, and even getting to keep the entire balance. A "Qualified Domestic Relations Order" (QDRO) is a court order, decree, or judgement; that recognizes a spouse, former spouse, child, or other dependent's interest in an individual's retirement benefits. QDROs are used for defined-benefit plans (what many people refer to as "pensions") and defined-contribution plans. The following are some examples of defined-contribution plans you may be familiar with:
This is not an exhaustive list of plans in which a QDRO can be used. Also noteworthy, a QDRO can also be used for a 457 Plan which is a form of deferred-compensation plan that is common among government employees and nonprofits.
SPECIAL NOTE: Federal government retirement benefits such as the Civil Service Retirement System (CSRS) and Federal Employees Retirement System (FERS), or State provided benefits such as CalPERS and CalSTRS (California) are divisible by a Court Order Acceptable for Processing (COAP) or Domestic Relations Order (DRO). The Federal Thrift Savings Plan is divisible by a Retirement Benefits Court Order (RBCO). If any of these plans pertain to you, please contact us for further guidance.
When a defined-contribution plan account is divided with a QDRO, it is usually split up in terms of a percentage or dollar amount of the account balance(s). The account balance(s) to be divvied up will consist of contributions and earnings (including any employer contributions) during the marriage. The divisible account balance does not include additional contributions by the participant and employer from the date of separation to the date the dissolution is actually finalized with the court. However, it will include any investment earnings on the alternate payees' (non-participating ex-spouse) applicable portion of the account up until the account is actually split. These nuances are why we do not believe doing a QDRO on your own is in your best interest, and that you go consult a qualified professional instead. You only get one chance to do this the way you want!
When a defined-benefit plan (commonly referred to as a "pension") is divided with a QDRO, the formulas used can be quite different because defined-benefit plans can be very different from one another and are also very different than defined-contribution plans. To get started, the plan participant or "member" of the pension plan would generally ask the plan administrator for a calculation of benefits as of a specific date, such as the date of separation or retirement. This can include a pension lump sum valuation and/or projected lifetime payments starting at a specific point in time (annuities).
As an example, the formulas could incorporate the total amount of years the participant worked for the employer or was eligible for participation in the retirement benefit plan, and the length of the marriage. Of course, if the participant/member continues to work for that employer, the actual separation of assets in that plan may not be allowed until the participant retires, which could be decades later! Once again, this depends entirely on what the plan allows and what your legal counsel recommends. There could be many nuances to any applicable survivor benefits as well. If this sounds like your situation, we feel further guidance from a legal professional is even more important.
What Does The QDRO Process Look Like?
The QDRO process starts with an attorney or a professional that is skilled in QDROs. After meeting with the parties and determining how the assets should be separated, they send a draft to the Plan Administrator who has to determine whether or not the requirements for the QDRO can be met in accordance with that particular plan (pre-approval). The reason for this is that the employer retirement plan's "Summary Plan Document" (SPD) rules all; meaning if the plan document says something is not allowed by the plan, it's not allowed. The QDRO cannot change that. After it has been reviewed by the Plan Administrator, both parties can sign it and the attorney or person who drafted it can then file it with court. The amount of time it takes for the court to review can vary based on your county's court system. We know around our area, it averages between 4 and 6 weeks. The QDRO is then sent back to the Plan Administrator to process the division of benefits.
What Options Does The Alternate Payee Have After A QDRO Is Complete?
Once the QDRO is completed, the institution holding the assets will provide options on how the alternate payee may receive the funds. First the institution will create a separate account in the alternate payee's name. At this point, the assets may still be invested as they were prior to the split and therefore subject to market risk. The alternate payee can then choose to: take it all in cash (receive distribution), leave it in the plan (if the plan allows), transfer to your own employer sponsored plan (if your plan allows), or roll it to an IRA at that institution or another. They usually have options that allow a mixture between those as well.
NOTE: Normally, any portion elected to be received as a distribution (cash) will be subject to ordinary income taxes and a potential 10% early withdrawal penalty if under age 59 1/2. However under a QDRO, if the funds are left in the plan (not rolled to IRA), distributions can be taken subject to only ordinary income tax (no 10% penalty regardless of age).
If elected to be rolled to an IRA, the alternate payee can delay income taxation until later, but still loses the ability to avoid the 10% early withdrawal penalty. So why not always leave the assets in the plan? Exactly how long the alternate payee can leave their money in the qualified plan depends on that plans specific rules. If the alternate payee is in need of some or all of the money immediately, it may be advisable to take distributions while it is still in the employer plan. One reason you may not want to leave it could be that you will only be able to invest in the investments that plan offers; and if the employer ever changes plan providers, your investments will have to change too. IRAs can offer more investment flexibility. Talk with your advisor to determine what is right for you.
What About Splitting IRAs?
The process of splitting IRAs in a divorce is handled differently than with the previously mentioned plans. Read our article or contact us for further guidance if you are considering splitting up an IRA.
Cameron Valadez is a CFP® Practitioner located in Riverside, CA.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
This is meant for educational purposes only. It should not be considered legal, tax or investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with your professional advisors regarding your personal situation prior to making any financial related decisions.