Very few employers have
any desire to get caught in the middle of the divorce proceedings of
their employees; however, when company retirement benefits become part
of the negotiations, unsuspecting employers can be pulled into the
One of the foundational rules for qualified retirement plans is
that participants' benefits cannot be pledged as collateral or
assigned to another party. Conditioning the plan's tax-favored status
on this prohibition helps to protect participant benefits; however,
there are a small number of exceptions to this rule.
One such exception is that benefits can be included in marital
property and assigned to a former spouse as part of domestic relations
proceedings. This is accomplished via a Qualified Domestic Relations
Order or QDRO.
What is a QDRO?
As the name suggests, a QDRO is a court order issued pursuant to
state domestic relations laws (Domestic Relations Order or DRO) that
is used to assign company provided benefits to an alternate payee,
typically as part of divorce or marital separation proceedings.
Although the rules governing QDROs are relatively straightforward,
many divorce attorneys tasked with drafting them are unfamiliar with
the nuances of qualified retirement plans. That can make an otherwise
simple situation very complicated very quickly…and when dealing with
the emotionally charged setting of a divorce, complication can lead to
There are several key elements that must be included in a domestic
relations order for it to be considered a QDRO.
Identification of the Parties
The order must identify the plan, participant and the alternate
payee, i.e., the party receiving benefits. This requirement is
usually, but not always, easily satisfied. For example, an order that
identifies the plan as the ABC Company's retirement plan may be
sufficient if ABC Company has only sponsored a single retirement plan.
However, if ABC has both a 401(k) plan and a cash balance plan, the
order would be too vague without specifically naming the plan to which
Data privacy concerns have led many to discontinue including social
security numbers as a means of identifying the participant and
alternate payee, so there must be sufficient information included to
ensure proper identification of all parties. This may be an easy task
in most cases, but further detail may be needed if a participant's
name is John Smith.
Description of Benefits
The order must clearly articulate the amount of benefits to be paid
or a formula for determining the benefits. For example, an order may
require a participant to pay a former spouse $50,000. Alternatively,
it may describe the benefit as 50% of the vested account balance as of
a specified date. These two may be combined to ensure a minimum or
maximum level of benefits, e.g., 50% of the vested account balance as
of January 1, 2011, subject to a minimum amount of $50,000.
Then, there is the question of investment performance. If there is
a lag between the determination date (January 1, 2011 in the above
example) and the date the benefits are actually paid, the order should
specify if the alternate payee is to share in any investment gains or
losses during the interim.
Purpose and Direction of Payment
A QDRO must provide child support, alimony or other marital
property rights. Although the alternate payee is typically a spouse,
former spouse, child or other dependent, benefits can be payable to
another entity for the benefit of one of these parties. For example,
the order may direct payment to a state department of family services
to provide benefits for a participant's child.
Just as some items are required, other provisions will disqualify
Inconsistency with Plan Provisions
An order is not permitted to provide a type or a form of benefit or
a benefit option the plan does not otherwise provide. For example, if
a plan does not allow distribution in the form of an annuity, a DRO
related to that plan cannot be qualified if it requires an annuity.
Amount of Benefits
An order cannot provide benefits greater than the benefits
available to the participant without the QDRO. For example, if a
participant's account balance is $45,000, a DRO assigning benefits
equal to $50,000 cannot be qualified. That is why many orders describe
the amount payable as a percentage of the participant's benefits
rather than as a flat dollar amount, especially in light of the
economic volatility experienced over the last several years.
Conflict with Previous QDRO
In the event a previous QDRO has assigned benefits to an alternate
payee, a subsequent DRO cannot assign those same benefits to a
different alternate payee. During 2010, the Department of Labor
published new regulations clarifying this issue. The regulations
specify that receipt of a DRO after an event such as a death or
divorce or after receipt of another QDRO does not necessarily mean
there is a conflict. Rather, the substance of the order(s) must be
As long as payments under the first QDRO have not already
commenced, a subsequent order modifying the amount is not, per se, a
conflict. Similarly, if a participant who is already subject to one
QDRO becomes subject to another, there is no conflict as long as the
subsequent order does not attempt to assign the same benefits
addressed in the first order.
All plans are required to have procedures that describe how DROs
will be processed and reviewed to determine their qualified status.
Among other things, the procedure should specify the timing within
which the review will take place and outline the flow of communication
among the parties.
On receipt of an order, the plan sponsor should take immediate
steps to freeze loans and distributions of the participant's benefits
during the review period. The freeze should generally remain in effect
until the earlier of:
18 months from the date the benefit was frozen;
The date distribution is made to the alternate payee;
The date the plan sponsor receives a court order releasing the
participant's benefit from the freeze; or
At the end of the 30-day appeal period that begins upon the
alternate payee's notification the DRO has been denied if no appeal
Don't Make Assumptions
While the rules described in this article are not necessarily
complicated, the facts and circumstances of each situation bring
unique details to be considered. As a result, each proposed QDRO
should be reviewed carefully. Whether it is identification of the plan
from which benefits will be paid or the calculation of the benefit
itself or anything in between, any confusion should be clarified with
the attorneys representing the parties.
It may be tempting to make assumptions in the interest of expedited
processing; however, if those assumptions are incorrect and lead to
improper payment of benefits, the plan sponsor may be held liable to
make the parties whole. Although divorcing spouses are typically on
opposite sides of the negotiation, they can unite very quickly against
an employer who has incorrectly processed a QDRO.
Death and Taxes
As the saying goes, death and taxes are both unavoidable, and the
same is true with QDROs.
When an ex-spouse receives distribution of plan benefits pursuant
to a QDRO, he or she is responsible to pay the associated income tax.
While this may seem obvious, both parties do not always understand
that fact. Sometimes, however, the parties do understand and try to
renegotiate the tax liability.
There was a Tax Court case in 1996 that dealt with this very issue.
The QDRO in that case was written to shift the tax liability from the
alternate payee (the ex-spouse) to the participant, but the Court held
that the terms of a QDRO cannot override federal tax law and required
the ex-spouse to pay the associated taxes. This does not mean that the
parties cannot negotiate the principal amount of the QDRO payment to
"gross-up" the alternate payee for the anticipated tax liability.
Distributions made pursuant to QDROs are generally taxed in the
same manner as any other "typical" plan distribution (other than
hardship distributions or required minimum distributions). The
alternate payee has the option to receive payment in any form
permitted by the plan, e.g., lump sum, installment, etc. He or she
also has the option to take the payment as a cash-out or rollover into
an IRA or another qualified plan. One key difference is that alternate
payees who elect a cash-out distribution are not subject to the 10%
early withdrawal penalty if the distribution is taken directly from
The potential for QDRO-related confusion does not always stop when
payment has been made. It is not uncommon for a participant to assume
that a QDRO officially concludes any right that his or her former
spouse may have to retirement benefits. However, an ex-spouse may be
listed as the participant's beneficiary. The federal courts see a
number of cases each year involving "unintended" payment of death
benefits. The typical scenario goes something like this…
A participant and second spouse go through a divorce, and the
second spouse receives half of the participant's retirement benefits
via QDRO. Fast-forward a few years to the participant's death. The
participant has a will leaving all remaining assets to his or her
children from the first marriage. However, the most recent plan
beneficiary designation on file lists the second spouse as the
primary beneficiary, because the participant forgot to file a new
designation following the second divorce.
Since a beneficiary designation is considered a plan document,
the sponsor follows the form on file and pays all remaining
retirement benefits to the now-former second spouse. The children
from the first marriage file suit, naming the second spouse and the
While the facts of each case are unique, the plan sponsor in this
fact pattern is generally correct in paying benefits to the person
named on the most recent beneficiary designation form. The
participant's will may determine how assets outside the plan are paid
but it has no bearing on the payment of plan benefits. As a result, it
is recommended as part of the QDRO procedure that plan sponsors remind
participants to update their beneficiary designations.
Divorces can be messy, and financial negotiations can make an
already heated situation reach a boiling point. Understanding the
rules of engagement and clearly documenting procedures can keep the
plan sponsor's role to one of "just business" and minimize the
liability associated with being pulled into the middle of an
emotionally charged situation.
The information contained in this newsletter is
intended to provide general information on matters of interest in the
area of qualified retirement plans and is distributed with the
understanding that the publisher and distributor are not rendering
legal, tax or other professional advice. You should not act or rely on
any information in this newsletter without first seeking the advice of
a qualified tax advisor such as an attorney or CPA.