What Is a QDRO?
A QDRO, pronounced “kwa-dro”, or Qualified Domestic Relations Order, is a court order granting a non-employee spouse the right to part of the retirement benefits their former spouse has accumulated in their company’s retirement plan.
If you are divorcing a spouse with a company retirement plan governed by The Employee Retirement Income Security Act of 1974 or ERISA such as a 401k or a pension plan, you will need a QDRO to receive those funds. The QDRO process has a definitive flow, its own terminology and can take some time to complete. We will walk through an example of a couple where the husband works at ABC Company and the wife is receiving a portion of the ABC Company 401k from her husband. In this example we will walk through the process from settlement in mediation to QDRO funds receipt to give the reader a better understanding of QDRO terminology, how the process works and the timeline.
Terminology with QDRO’s is important but thankfully, fairly straightforward:
- Plan: This is the specific retirement plan to which the order applies. You need a QDRO for each plan. For example, if you are divorcing an ExxonMobil employee, you could be awarded a portion of ExxonMobil 401k and the ExxonMobil pension plan. Those are two different plans and two different QDRO’s will be needed. (Note there are other plans at ExxonMobil for certain employees such as Restricted Stock Units and Supplement Pension Plans – those are not ERISA plans and do not need QDROs but have their own issues we will cover in a separate article).
- Participant: This is the individual who will be assigning his or her benefits to an alternate payee. This is the spouse who works for the company and whose name the plan is under.
- Alternate Payee: This is the individual (usually a former spouse) who will receive the benefits.
- Address of Record: The address on the QDRO form for the alternate payee and the participant is what will be used by the QDRO department to communicate with you. It is critical to have the correct address listed as this is how you will receive communication.
Description of Benefits
The order must clearly articulate the benefit to be assigned to the alternate payee. The order could use a flat dollar amount or a formula.
Here are two examples:
- Flat dollar amount: $500,000
- Formula: 50% of the participant’s vested account balance as of January 1, 2023, adjusted for any investment gains or losses, stock splits, dividends and/or interest from January 1, 2023 through the date of distribution.
In a turbulent market such as 2022, this is a critical element to understand. If you were awarded 50% of a 401k balance in April of 2022 which was invested in growth stocks, and then didn’t take receipt until August of 2022 – that balance may be much lower over the time period. Likewise, if you only owned oil and gas stock during that same time period, you may be very happy you were awarded gains and losses as the account could have grown considerably. We cannot over-emphasize the importance of considering investment performance as there is a lag between the determination date (January 1, 2023 in the above example) and the date the benefits are actually set aside for the alternate payee (August of 2023 in our example below).
It’s important to understand if you are receiving a flat dollar amount or a percentage split and if the percentages include gains, losses, interest, and dividends. (And no, you will not usually get an opposing attorney to agree that you only participate in the gains but not the losses.)
Which option is better? Well, that depends. When and if we suggest flat dollar amounts in QDRO’s it is because the parties have usually agreed to a set amount as part of an overall division and for a specific purpose – like paying off debt or purchasing a new house. Our concern is always if you are awarded a set dollar amount, what happens if the market falls and those dollars do not exist months later when the QDRO order is completed? That becomes an issue.
Awarding the alternate payee a portion of the account on a percentage basis with gains, losses, dividends and interest from the date of division to the date of distribution is certainly more prevalent in our experience. This is more prevalent as both parties participate fully in the risk or reward of the markets from the time of division until the funds are distributed.
QDRO Timeline – April Division to August Receipt of Funds
It takes several months from the date of division to the date of receipt. Let’s continue with our example. Jane and John went to mediation on April 2. In mediation, the parties agreed on a settlement which awarded Jane 52% of the ABC Company 401k of her spouse John. They signed a Mediated Settlement Agreement or MSA which was final and binding on April 2. The next day the wife’s attorney calls a QDRO firm and asks them to draft a QDRO’s for this settlement.
It then took until May 15 for the decree to be finalized. The attorneys had to draft the decree, agree on the language in the drafting and then set a court date to finalize the divorce with the court. This all required effort and time. During that time a QDRO firm created a QDRO for the 401k, sent the QDRO’s into ABC Company’s custodian for preapproval and it came back approved. The parties were officially divorced on May 15 via a “prove up” in court. The divorce decree and the QDRO were all entered together and signed by the judge.
The wife paid extra for the QDRO company to pick up the QDRO in the clerk’s office and send it to ABC Company after a judge’s signature was secured. The county clerk is not responsible for this, the QDRO firm is not automatically responsible for this – the receiving party is responsible. Sometimes the QDRO firm who drafted the QDRO will do this, but you must confirm with them. It is not automatic and usually involves an extra fee. In this example the wife paid an extra $100 to the QDRO firm and they picked up the signed QDRO from the county clerk’s office and sent it to the company which manages ABC Company’s 401k.
About 30-45 later, ABC Company sends a letter to the wife’s address of record notifying her the QDRO has been received and is being reviewed. Now the alternate payee or former wife can call ABC Company and discuss the QDRO with them. However, ABC must still review the QDRO and confirm it is accurate. If you had a QDRO firm prepare your QDRO and send it in for pre-approval, this should not be an issue. In our example, let’s assume the letter was received by Jane on June 25.
ABC Company must still review the QDRO which takes another 30-40 days. On approximately August 2 in our example ABC sent a second letter to the alternate payee for the 401k QDRO letting her know the QDRO is approved, an alternate payee account now exists and they provide distribution options.
In this example, the division of assets was decided on April 2, but the account was not available until August for the former wife.
Although this step frequently occurs at the same or immediately following the account segregation, it is important for the plan to follow the normal distribution process. In other words, the alternate payee must be provided with the necessary disclosures and then must submit the regular distribution request forms. Most plans include language that allows the alternate payee to take a distribution right away, but some plans limit that ability until the participant would otherwise be able to take a distribution. When distributions are permitted right away, it is our experience that the alternate payee is usually eager to do so.
When an ex-spouse receives a cash distribution of plan benefits pursuant to a QDRO, he or she is responsible to pay the associated income tax. You are taxed on these funds at your ordinary income rates as if you had a job which paid you the same amount.
One key difference is that a cash-out distribution from a QDRO is not subject to the 10% early withdrawal penalty. For example, going back to Jane Smith, she is 45 years old. If she were to take funds out of a pre-tax retirement account to use as cash, she would pay tax on the proceeds in addition to a 10% penalty. However, if the cash withdrawal is from the QDRO funds directly, the 10% penalty is not applied. Let’s assume Jane needs $100,000 to establish an emergency fund, pay divorce debt and buy a new car. She would take $100,000 of her QDRO in cash and pay taxes based on her marginal tax bracket that year. The remainder of her QDRO funds could be rolled into an IRA in her name alone without any tax liability due today. Divorces can be messy, and financial negotiations can make an already heated situation reach a boiling point. We find it is helpful to have someone who understands this process and can guide you. If you have QDRO questions, please schedule a strategy session with us to discuss what your next step should be. We can not only help you receive your QDRO funds but we can help you map out a plan for how much tax you should send to the IRS, how much you need in cash and an investment strategy for the funds you move into your own account through our partner investment firm.