Qualified domestic relations order tax consequences

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

qualified domestic relations order, employee benefit plans, accounting, auditDivorces can cause years of planning, saving and growth to be washed away in the blink of an eye, leaving you reevaluating the retirement that you had once planned. A qualified domestic relations order (QDRO) is a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant.

Most of the time, it grants a person a right to a portion of the retirement benefits his or her former spouse has earned through participation in an employer-sponsored retirement plan. The plan administrator who oversees the retirement benefits subject to the order will determine if a domestic relations order is a qualified domestic relations order.

Listen now: Preparing for divorce financially

Of course, with anything involving money, there are tax implications.

A spouse or former spouse who receives QDRO benefits from a retirement plan reports the payments received as if he or she were a plan participant. A QDRO distribution that is paid to a child or other dependent is taxed to the plan participant. You may be able to roll over tax-free all or part of a distribution from a qualified retirement plan that you received under a QDRO.

Best described in an example, if a husband has a 401(k) plan with a $100,000 balance and must take a $50,000 distribution to pay his ex-wife stemming from their divorce agreement, the husband will incur a 10% early withdrawal penalty and must pay income taxes on the distribution. Assuming an effective tax rate of 20%, the husband would incur $15,000 in taxes and penalties on the $50,000 payment to his ex-wife.

On the other hand, if the husband transfers $50,000 to his ex-wife via QDRO from his 401(k) plan, there are no tax consequences to him. The ex-wife would have the choice to either cash the monies (which avoids the 10% early withdrawal penalty, but still triggers the ex-wife the payment of taxes on the distribution), or the ex-wife can keep the monies in a qualified retirement account (e.g., an IRA) and continue deferring the tax consequences.

Divorces are becoming more common every year. It is important to understand the financial implications that can go into a divorce and having proper legal representation throughout a QDRO process can result in avoiding adverse consequences to one or both parties.

CJ McGrady