A QUALIFIED DOMESTIC relations order (QDRO) under Internal Revenue Code Section 414(p)(1)(A) refers to a domestic relations order that creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits paid with respect to a participant under an employer’s retirement plan.

In other words, a QDRO is a set of directions to a plan administrator as to how to pay a divorced spouse, child, or other dependent (alternate payee) all or a part of a pension benefit.

Being an Internal Revenue Code definition means there are dos and don’ts associated with the QDRO. Let’s start with what this type of order cannot do.

It cannot:

• provide any type or form benefit or option not provided under the plan;
• provide benefits exceeding actuarial values;
• provide payments of benefits already assigned to someone else;
• split individual retirement accounts, military, and certain government plans.

A QDRO is intended to apply to the plans covered by the Employee Retirement Income Security Act (ERISA) that many private-sector employers offer their employees.

Types of QDRO

There are two types of qualified retirement plans: defined-contribution and defined-benefit plans.

Defined Contribution Plans

A defined contribution plan does just what the name indicates: it provides the employee with a stated contribution. Depending on the plan, the employer, employee, or both can make contributions. The end result is an account balance belonging to the employee. Examples of defined contribution plans include 401(k), 403(b), and profit-sharing plans.

Although defined contribution plans — with their definite account balances — are relatively simple to deal with, there are some pitfalls to be avoided when drafting QDROs for them.

One issue involves loans. Often a defined contribution plan will allow the plan participant to borrow, within limits, from his or her account balance. The QDRO should state whether or not the loan balance should be included or excluded in the asset division.

Another area of concern is how account earnings are treated. The QDRO should specify how the earnings are divided between spouses from the date of allocation until the amount is set aside or distributed.

Year-end contributions often pose problems as well. Employer discretionary contributions are often decided and made after the business’ year-end. To ignore these contributions in a division of the account balance for a particular year may mean the client misses out on receiving a portion of these funds.

Finally, vesting schedules are also problematic. Vesting refers to the portion of the account balance that the plan participant keeps should he or she leave the company.

Using the 401(k) plan for example, the employee contributions are 100 percent vested, but the employer contributions are often vested over a set schedule. The schedule could be zero percent in years one and two, 20 percent in year three, 40 percent in year four, 60 percent in year five, 80 percent in year six, and 100 percent in year seven. The QDRO should specify whether it is the vested balance or both, vested and unvested, balances that are being divided.

Consider the scenario where the employee spouse’s full retirement account balance is used in deciding the asset split. At the time of the split, the employee is 60 percent vested in the balance. Should the em ployee leave the company any time over the next three years, the non-vested funds would no longer be part of the asset.

Defined Benefit Plans

The second general type of retirement plan is a defined benefit plan. Once again, the name indicates what the plan is set up to do: provide a benefit at a specific point in time.

Usually, the benefit is based on some type of formula. Included in the calculation can be the number of years worked before retirement and the pay the employee was earning. Because the benefits are based on a simple promise for a future date they are much harder to deal with in divorce situations. The value is dependent on many factors.

The future date is usually termed the participant’s "normal retirement date," typically at age 65 or 67. Some plans allow an employee to start drawing benefits before the normal retirement date. Generally, the benefit is reduced given the fact it must be paid over a greater time span (i.e., age 55 instead of 65). The plan provisions will state what options are available.

Benefits can be paid over the participant’s lifetime only, ending upon death. Benefits can also be paid over the participant’s and the spouse’s lifetimes, this is known as a joint and survivor annuity. The terms of the plan will dictate the amount of the annuity and the choices.

While married, an employee’s spouse is entitled to benefits and cannot be cut from those benefits without his or her consent. After a divorce, the spouse’s rights cease.

Defined pension plan benefits are divided through methods, including "cash-out," deferred division, or reserved jurisdiction:

• The cash-out method basically awards the non-employee spouse an asset equal to the value of the pension. The employee spouse retains the pension.
• The deferred division waits until the benefits are paid and awards each spouse a share.
• The reserved jurisdiction allows the court to retain the authority to order distributions from the plan at some point in the future.

A point to consider is the value of the pension at retirement age based on today’s earnings and time with the company. Another issue to take into account is the employee’s anticipated earnings over the time period. This is critical in determining the value today, and the plan administrator should be asked to clarify if any doubt exists.

As the involved parties determine assets and benefits, they should consider the alternatives of taking the retirement benefit or another asset. In doing so, the number of years until retirement should be considered. Not only are the employment years uncertain, but also the stability of the plan.

It should be noted that the pension value is dependent on the discount rate used to calculate the present value of the income stream of the benefits.

What happens if the employee’s spouse chooses not to retire when eligible? Maybe the spouse will not receive any of the pension benefits under these circumstances. A relevant question to ask is: What does the spouse have for a benefit at retirement time if the employee hasn’t retired?

Additional questions that should be asked of the plan administrator prior to drafting the QDRO are:

• Does the plan allow a QDRO?
• Does the plan pay benefits in a lump sum?
• Does the plan separate accounts?
• Can the non-employee spouse receive benefits before the employee spouse retires?
• What happens if the employee elects early retirement?
• What if the employee dies before retirement?
• What if the employee dies after retirement?
• What if the non-employee dies before receipt of the pension?
• What if the non-employee dies after the receipt of the pension?
• Is there any bonus for early retirement from the plan?
• Can either spouse be named beneficiary of the survivor benefit? Is it a good idea to do so?
• Can percentage splits be directed by the QDRO?

These questions point out the real issue — know the plan’s provisions before drafting a QDRO. Be familiar with at least the summary plan description.

Also, be careful regarding the valuation date requested for the division of the defined benefit account. The QDRO may ask for division as of the date of the divorce decree, but if the plan doesn’t value its asset at that date the QDRO will be rejected.

Speaking of rejected QDROs, make certain, if possible, that the plan administrator approves the QDRO before a divorce is final. Not only could this prevent embarrassment, but the non-employee spouse’s rights remain protected as well. The non-employee spouse could end up with no benefits if, between the time of divorce and QDRO approval, the employee spouse retires, dies, or remarries.

Know the Plan Before Drafting the QDRO

Extensive information on retirement benefits must be obtained in order to prepare the QDRO. The information should be used to decide the best course of action for the client. This means modeling the financial outcome of the proposed asset split. The model should reflect the spouse’s current and retirement income needs.

For example, one spouse receives the house and the other spouse retains the pension benefits. What happens five years down the road to the financial picture of the spouse? How about 10 years in the future? Can the spouse without the pension survive during retirement? Can the other spouse support the cost of the house?

Keep in mind, while the tax deferral on most retirement plans is a powerful asset builder, the client may need cash today. The answer may depend on when the employee spouse will retire and on the other income and assets he or she has, or will have. Modeling different scenarios will help with the decision process.

When splitting assets, consider the tax basis of the asset. If an asset has to be sold and has a low tax basis the client may end up with less money than originally anticipated because he or she will need the money from the sale to pay the taxes on the gain generated by the sale.

Adequate consideration should be given to the after-tax consequences of all property transfers to both spouses, along with the cash and income needs of each. Is it equal distribution if a high-bracket spouse receives all of the qualified assets while the other receives low-basis, non-qualified assets? What if a pre-retirement-age spouse receives all the qualified plan assets in a QDRO but needs cash? Equal distribution may not be intended but all consequences must be considered.

As a final note, the divorce lawyer may want to consult a tax advisor and a financial advisor during the divorce process. The teamwork of compatible professionals can lead to a better financial outcome for the client.

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