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
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 unpleasantness.
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 it referred.
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 is filed.
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
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 plan.
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
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 plan sponsor.
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
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.