Alan Pearlman, who writes the Chicago Family Law Blog, has a great article on the tax side of dividing retirement assets upon divorce:
It is reprinted below. Thanks, Alan.
"An increasingly large portion of the assets of married couples consist of rights to payments and stock from pension plans. In many states such assets are subject to division during a divorce. Divorce and division of property are generally controlled by state law, but pension plans are controlled by federal law in many respects.
Pension Plans and ERISA
A major advantage of saving for retirement through a pension plan is that contributions from employees and employers for plans such as a 401(k) plan are not taxed as income until distributed by the plan, usually after retirement, at lower tax rates. However, under provisions of the Federal Internal Revenue Code, the assignment of pension benefits, including transfers to a spouse during divorce, may result in the loss of such tax benefits.
In 1984, Congress passed the Employee Retirement Income Security Act (ERISA), which governs most private pension plans (government and some other plans are not covered, nor are IRAs). To remedy the anti-assignment problem, the Retirement Equity Act of 1984 (REA) amended ERISA to establish an exception to the anti-assignment bar to division of ERISA plan benefits during divorce.
Federal Tax Treatment of QDRO Plan Distributions
To avoid adverse tax consequences, the plan participant/spouse must obtain a "Qualified Domestic Relations Order" (QDRO). A QDRO is usually entered by the court, although under certain circumstances other entities may approve a QDRO. The QDRO must also be approved by the administrator of each plan affected.
The QDRO must contain certain information specified in ERISA, as amended by REA, including the names and addresses of the plan participant and the recipient(s) of the court award (the "alternate payee"). There are also certain provisions that are prohibited in a QDRO, including the authorization of plan benefits and payouts that are not allowed by the plan.
A QDRO creates or recognizes an "alternate payee's" right to receive all or a portion of the plan benefits, or it may actually assign that right to the "alternate payee." An "alternate payee" may only be a spouse, former spouse, child, or other dependent of the plan participant. A validly created and approved QDRO allows the recipient spouse to be treated, for federal income tax purposes, as a plan participant. In addition, the QDRO may allow the alternate payee to take a lump sum withdrawal (if allowed by the plan) or commence payments at the earliest time allowed for retirement, regardless of when the participant actually retires.
Consequences of Plan Withdrawals Absent a QDRO
If a court orders the division of an interest in an ERISA pension plan during a divorce and the plan participant simply pays the amount from the pension plan without obtaining a QDRO, the participant may become liable for an early withdrawal penalty of 10% (depending on age and method of withdrawal), plus income and/or capital gains taxes on the amounts distributed to the former spouse. Federal courts have repeatedly upheld this principle, despite claims of plan participants that they were forced to comply with the court's order and had no other source for the payments, and therefore should not be penalized.
Absent a QDRO, the amount withdrawn from the plan thus becomes income and/or capital gains to the plan participant, not the former spouse. If a valid QDRO is in place, however, the distributions from the plan are treated as income and/or capital gains to the alternate payee/spouse. However, if distributions from the plan are used to satisfy child support or payments to some other dependent of the plan participant/spouse, the distributions are still treated as taxable to the plan participant/spouse for federal income tax purposes, notwithstanding the existence of the QDRO.
Alan Pearlman, the Chicago Family Law Blog, May 12, 2006