Tax Consquences of Divorce: Enter the QDRO

Earlier this week, we had a brief opportunity to mention Qualified Domestic Relations Orders in the context of retiree divorce. Because of the rising Baby Boomer divorce rate, and the tax consequences of fiddling with retirement accounts, these important devices deserve further discussion.

A QDRO (pronounced "quad-row") is a bit of paperwork that splits a retirement account into two, usually in the context of a divorce. These are especially important because in many cases, they can avoid the tax consequences of early withdraw or assignment of retirement benefits.

Divorce and Taxes

One of the glorious provisions of our federal tax code is the ability to postpone and reduce taxation on income by diverting certain amounts into retirement accounts such as 401(k)s. By doing so, the funds are not taxed until they are distributed or assigned, and when they are taxed, it is typically at a lower rate than they would have been initially.

However, when spouses split, they may have the right to part of their ex-spouse's retirement accounts. Absent an agreement otherwise, income after marriage -- including diverted income into retirement accounts -- is considered marital property. But if the account is cashed out at the time of divorce, there are a number of penalties for early withdraw, plus the near certainty of taxation. Also, if cash is withdrawn from the plan, it is taxed to the plan participant, not the participant's spouse. Handing over money in a divorce and having to pay taxes on it seems a bit unfair, right?

Enter the QDRO (and QILDRO)

No, it's not a Wu-Tang album. The QDRO is an exception in the federal ERISA statute that allows for the assignment of benefits in the event of a divorce. Illinois' state equivalent is the QILDRO, which doesn't sound nearly as nice.

As complicated as it may seem, and as it may be to draft one from scratch, a QDRO is simply a document with a number of statutorily required elements, such as the name of the plan participant, the assignee of the benefits, and the account information. There is an additional bonus to a QDRO as well: In some instances, it may be possible to assign the benefits to a child instead of that dirty, lying, cheating, ex-spouse. This is, of course, assuming such an arrangement is agreed upon in the divorce settlement.

In practice, most lawyers will not need to draft a QDRO from scratch. This is because most major retirement accounts have their own preferred form that meets the federal ERISA requirements. They do this to avoid dozens of sloppily drafted documents by a multitude of impatient attorneys. This standardizes the process, saves everyone time, and more importantly, saves the client a bit of legal fees.

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