If you are involved in a divorce and have retirement accounts to divide, you will likely need a qualified domestic relations order, or QDRO. This is a court order that authorizes your plan administrator to divide your IRA, 401(k), pension or another retirement account without creating a taxable event.
As you may know, there are tax advantages to putting money away in IRAs, 401(k)s and 403(b)s. In most of these, the money you put in is tax deductible up to a certain point, meaning that you essentially put the money into the account before paying taxes on it.
As long as you keep the money in the account until you reach a certain age (typically 59-1/2), you don’t have to pay taxes on the money at all. If you withdraw the money before that age, however, you end up owing the taxes and paying an early withdrawal penalty.
What does this mean for divorce? Suppose all of the retirement savings are in Spouse A’s 401(k) and a shared IRA. The couple agrees that Spouse B should receive half of the 401(k) money and half of the IRA. If Spouse A were simply to withdraw the money and hand it over to Spouse B, however, Spouse A would incur costly taxes and penalties (assuming Spouse A is under age 59-1/2).
The way to avoid these taxes and penalties is to ensure that the trustee managing your retirement account (the administrator or custodian) makes the required transfers directly into another trustee-managed, tax-advantaged account.
Whether it was negotiated or ordered by the court, your decree needs to cover all of your retirement accounts and specify not only how, but also when the accounts should be divided. That said, a divorce settlement or decree is not legally sufficient to allow an administrator or custodian to perform the division.
For that, you need a QDRO. The trustee managing your account cannot legally divide your account without a QDRO, and the order must comply with the plan’s overall rules. For example, if a particular plan doesn’t allow the transfer of any funds until Spouse A retires, the QDRO must comply with those rules and direct the division to occur at that time. If the QDRO does not comply with the plan’s rules, it will be ineffective.
Because QDROs must comply with the terms of the plan, it’s important to obtain the QDRO while your divorce is still pending. That way, if the plan’s trustee says that the QDRO does not comply with the plan terms, you can go back to court with a revised QDRO without having to reopen the case.