Avoiding QDRO Mistakes

No one wants to make QDRO mistakes when dividing retirement plans in a divorce. Retirement plans are typically among the most valuable assets in the marital estate. A QDRO, or qualified domestic relations order, is a method of dividing a retirement plan. QDRO mistakes may be costly. Still, retirement accounts typically contain pre-tax dollars that are not as valuable as their face value. In Chapter 13 of my book, we examine how to control the tax consequences when retirement assets are divided. It is important to avoid QDRO mistakes like these when dividing retirement assets in divorce.

Don’t wait until you are drafting the QDRO to get the information you need to avoid QDRO mistakes. By taking the time to investigate and resolve these issues before the settlement is final, you will encounter fewer QDRO mistakes down the road. When you understand the details of the retirement plans, you can negotiate a settlement (or win at trial) in a way that will properly divide the assets, without coming back to haunt you long after the divorce is over.

Frumkes & Vertz on Divorce Taxation

What Are Some Mistakes to Avoid When Dividing Retirement Plans in Divorce?

1. When trading retirement benefits in a divorce settlement, consider the after-tax value but don’t leave money on the table. In many divorce cases, one spouse prefers to keep his or her retirement assets so it makes sense to offset them or trade for other assets, like real estate or bank accounts. In those cases, lawyers might obtain valuations that express the value of a retirement account in after-tax dollars. That makes it possible to trade a pension for a house or bank account, because both kinds of assets are described in after-tax values.

However, you don’t want to leave money on the table. If a pension valuation is expressed in after-tax dollars, you can trade it for equal value in real estate or cash, but then you have to gross-up the value of the retirement to its pre-tax value. Let’s take an example:

If a 401K contains $100,000, it might be worth $82,000 after taxes are paid. This assumes that an 18% federal income tax rate will apply when funds are withdrawn from the 401K. The couples also owns a home with $82,000 in equity. In most cases, the home will not have any tax liability when sold.

If we write a settlement where one spouse keeps the home, and conveys $82,000 from her 401K by QDRO (to pay for it, so to speak), then the other spouse will be cheated. When the funds are withdrawn from the 401K, the $82,000 will be worth $67,240. In order to make an equal trade, the $82,000 (which was the after-tax value of the 401K had to be grossed-up to its $100,000 pre-tax value. The spouse who was keeping the home should have paid $100,000 from her 401K as an equal exchange for an $82,000 house.

Chapter 13 contains many other QDRO mistakes that must be avoided:
2. If a retirement account contains pre-tax and after-tax dollars, then the QDRO should specify that the account will be divided pro rata. The tax benefits and liabilities associated with retirement accounts should be divided in the same shares as the retirement plan itself.
3. Dividing military pensions just got a lot more difficult, due to a major change in federal law in 2017. The Howell case, from the U.S. Supreme Court, allows a servicemember to get away with electing VA disability benefits, which can drain the military pension, even after a divorce settlement is final. If you are a servicemember’s former spouse, deal with this situation before you lose your share of the military pension.
4. Cash balance pension plans (including most state-sponsored plans) look like 401K plans but they are actually pension plans with an option to take a lump sum withdrawal. This mistake comes into play when spouses rely on account statements that mention a lump sum, which might not reflect the true value of the cash balance plan.
5. A spouse (or ex-) cannot effectively waive an interest in an ERISA-qualified retirement plan in settlement agreement or order if the participant does not change his or her beneficiary designation. The employee’s former spouse could get a windfall if the employee does not change his or her beneficiary designation after the divorce is final.

QDRO mistakes are costly, so get it right the first time. Don’t take chances when finalizing your divorce settlement and QDRO. In Pittsburgh and Western Pennsylvania, call Brian C. Vertz at 412-471-9000.