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 the fray.
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.
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.
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.
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 an
order.
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.
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 considered.
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.
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 QDRO.
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 second divorce.
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 designations.
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.
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