There are so many ways to save for retirement that it feels like you have to be a financial expert to understand the various retirement accounts available and their respective tax advantages. In reality, most retirement plans in the United States fall under the umbrella of being a “deferred compensation plan.”
Deferred compensation plans even at their most basic, still, usually, require a divorce atto
What Is A Deferred Compensation Plan?
A deferred compensation plan is ANY agreement between an employee and an employer that allows the employee to collect money they earn presently at a later date.
Why would anyone want to get paid for their work years later?
Deferred compensation plans exist because the employee will not be paid immediately and therefore will not be taxed immediately. For example, if an executive is in the top tax bracket and paying 37% of hit income in federal income tax plus Illinois’ 4.95% state income tax. Our hypothetical executive may wish to collect their income 5 years in the future when they are retired and only have to pay a 24% federal income tax and no state income tax in a zero-income tax state like Florida.
Furthermore, the income paid later is usually saved and invested pre-tax in the years before it is paid out so that income is actually higher on the payout date than it would have been if paid immediately.
Deferred compensation plans, once paid, have serious tax liabilities for whomever is cashing the funds in the plan. So, those tax liabilities must be considered if and when the marital portion of that plan is divided in an Illinois divorce.
Qualified Deferred Compensation Plans
Deferred compensation can be divided into two initial categories: qualified deferred compensation and non-qualified deferred compensation.
You are probably already familiar with qualified deferred compensation plans. The two most popular qualified deferred compensation plans are the 401(k) and 403(b) plans. These are the plans which are governed by federal law under the Employee Retirement Income Security Act (ERISA).
The 401(k) is a plan offered by a private employer which allows an employee to set aside income for retirement which will not be taxed in the current year.
The 403(b) is a plan offered by a not-for-profit employer (almost always a government entity) which allows an employee to set aside income for retirement which will not be taxed in the current year.
The practical difference between a 401(k) and a 403(b) is that a 401(k) will often offer an employer match for any money deposited into the 401(k) plan while a 403(b) rarely does that. In turn, employees who receive a 403(b) plan usually also receive a separate pension benefit.
These qualified deferred compensation plans have a lot of benefits and limitations.
A qualified deferred compensation plan cannot be seized by creditors and can be kept even after a personal bankruptcy. If the company that holds the 401(k) goes into bankruptcy, the company’s creditors also cannot touch the 401(k) holdings.
A qualified deferred compensation plan has contribution limits, however. So, it is rare to find a 401(k) or a 403(b) with millions of dollars of assets held in its accounts.
Qualified deferred compensation plans must be divided in a divorce via a Qualified Domestic Relations Order. These orders ensure that all parties are in compliance with ERISA in order to preserve the divided plan’s tax deferred character for both spouses.
Non-Qualified Deferred Compensation Plans
The maximum amount an employee can deposit into a 401(k) is $ 19,500 plus $ 6,500 if the employee is 50 year or older. For many high-income employees, $ 25,500 is not a lot of money.
Therefore, employers of highly-paid employees will offer non-qualified deferred compensation plans to further incentivize those highly-paid employees.
Non-qualified deferred compensation plans usually are categorized at 409(a) plans for for-profit employees or 457(b) plans for not-for-profit employees.
While these plans are governed by those respective tax codes, 409(a) and 457(b), they are not governed by ERISA. Therefore, there are no contribution limits but there are also no bankruptcy protections as provided by qualified deferred compensation plans.
Non-qualified deferred compensation plans are instead governed by a private contract between the employer and the employee. That contract must comply with some IRS regulations to defer taxation but the terms of the contract will be individual to each employee.
Because the terms of the contract are so individual, one can expect a non-qualified deferred compensation plan to include additional clauses such as a non-compete clause and other restrictions that ensure the employee will stay with the employer for a long period of time.
This is the whole point of non-qualified deferred compensation plan. Any employee who would want a non-qualified deferred compensation plan would also want to save more than $25,000 a year. Such an employee needs to be seriously incentivized.
In exchange for such large monetary incentives, the employer must be assured the employee will continue to perform at the same company.
Why don’t employers just offer a higher salary or a bonus?
A higher salary will be taxed at current marginal tax rates, thereby reducing over 40% of the salary increase’s effectiveness. A bonus is also taxed and not even promised until the bonus is actually paid, a high-income employee is going to consider that additional risk.
Still yet, non-qualified deferred compensation plans often look a lot like bonuses for the purposes of incentivizing the employee. Non-qualified deferred compensation can even be so intricate as to include stock options.
These positive incentives also come with negative incentives. Non-qualified deferred compensation plans often come with clauses which, if broken, would result in the employee forfeiting the non-deferred compensation plan.
Thus, non-deferred compensation plans are often referred to as “golden handcuffs.” Bottom line: a promised non-deferred compensation plan is very lucrative and will almost always be followed through with.
How Are Deferred Compensation Plans Divided In An Illinois Divorce?
The first determination in dividing any asset or interest in a divorce is determining whether that asset or interest is marital or non-marital.
“”[M]arital property” means all property, including debts and other obligations, acquired by either spouse subsequent to the marriage” 750 ILCS 5/503(a)
“The court shall make specific factual findings as to its classification of assets as marital or non-marital property” 750 ILCS 5/503(a)
Upon a determination as to whether an asset is marital or non-marital, it shall be divided (or not).
An Illinois divorce court “shall divide the marital property without regard to marital misconduct in just proportions” 750 ILCS 5/503(d)
“[T]he court shall assign each spouse’s non-marital property to that spouse.” 750 LCS 5/503(d)
Deferred compensation plans are often earned and contributed to both before the marriage date and after the marriage.
In such situations, the portion of a deferred compensation plan that was earned and contributed to before the marriage will be deemed non-marital and the amounts contributed and which increased over time will be deemed marital and, thus, divisible in an Illinois divorce.
Property acquired before the marriage date shall be deemed non-marital if “acquired before the marriage, except as it relates to retirement plans that may have both marital and non-marital characteristics” 750 ILCS 5/503(a)(6)
Furthermore, “[f]or purposes of distribution of property pursuant to this Section, all pension benefits (including pension benefits under the Illinois Pension Code, defined benefit plans, defined contribution plans and accounts, individual retirement accounts, and non-qualified plans) acquired by or participated in by either spouse after the marriage and before a judgment of dissolution of marriage or legal separation or declaration of invalidity of the marriage are presumed to be marital property.” 750 ILCS 5/503(b)(2)
There is no question that deferred compensation is a property that can be divided in an Illinois divorce. “[A]n employee’s pension interest is a contractual right to deferred compensation, and thus “property” In re Marriage of Hunt, 397 NE 2d 511 – Ill: Appellate Court, 1st Dist. 1979. “Retirement benefits earned during the marriage in the form of pensions and profit sharing interests are designated as marital property.” In re Marriage of Davis, 215 Ill. App. 3d 763, 773 (Ill. App. Ct. 1991)
For a qualified deferred compensation plan, this division is easy because ERISA requires that the plan itself provide for a mechanism to accurately and fairly divide a qualified deferred compensation plan which they administer.
“Each plan shall establish reasonable procedures to determine the qualified status of domestic relations orders and to administer distributions under such qualified orders.” 26 U.S. Code § 414(p)(2), ERISA § 206(d)(3)(G)(ii)
This involves filling out a Qualified Domestic Relations Order which is approved by the plan, signed by the judge and then executed by the plan in order to create two different plans from the current existing plan. This way, the tax deferred status of the plans is preserved post-division.
When it comes to dividing non-qualified deferred compensation plans, you’re on your own. A divorce attorney can prepare a Domestic Relations Order in order to divide the plan but it doesn’t need to meet ERISA guidelines. Furthermore, the calculation of the non-marital vs. marital amounts of the non-qualified deferred compensation plan must be calculated by the parties themselves. This usually involves hiring a CPA or actuary to make these complex calculations.
In addition to a Domestic Relations Order, the division of a non-qualified deferred compensation plan must be detailed with extreme specificity in the Marital Settlement Agreement. With a non-qualified deferred compensation plan there is no plan administrator is going to be double-checking your work to be sure you are in ERISA compliance. Failure to properly include information about a deferred compensation plan in a marital settlement agreement could constitute a waiver in any interest thereto. “By failing to name the…deferred compensation plan with the SERP Plan, it is clear that the parties did not intend to exclude the former from being divided equally between the parties” In re Marriage of Hendry, 949 NE 2d 716 – Ill: Appellate Court, 2nd Dist. 2011
Finally, deferred compensation plans will often have a survivor’s benefit, should the party pass away. The beneficiary will surely not be the ex-spouse or soon-to-be-ex-spouse but that doesn’t mean it’s not marital property. “[A] survivor’s benefit has a determinable value and it is properly considered a marital asset.” In re Marriage of Moore, 251 Ill. App. 3d 41, 44 (1993)
Roth IRAs vs. Deferred Compensation In An Illinois Divorce
It’s important to contrast the Roth IRA against deferred compensation plans in order to better understand how deferred compensation works.
Roth IRAs are paid for with post-tax income. The holder of a Roth IRA never has to pay taxes on the money that comes out of a ROTH IRA. The advantage of holding money in a Roth IRA versus a bank account is that capital gains taxes are not applied against any increase in the value of the Roth IRA. So, zero taxes come out when you take money out of a Roth IRA at age 59 ½ or later.
To preserve the zero capital gains and avoid withdrawal penalties before age 59 ½ , the parties should create a separate Roth IRA for transfer of the divided Roth IRA’s assets.
When a Roth IRA is divided between the parties, there are no tax implications so a QDRO is not necessary. Typically, most people who put money into a Roth IRA during their marriage also put money into a Roth IRA in their spouse’s name during the same period. So, both parties usually walk away with their respective Roth IRAs.
The point is, the entire purpose of a deferred compensation plan is to delay and reduce taxes. No taxes = no problems.
Deferred Compensation Plans And Child Support In An Illinois Divorce
In a deferred compensation plan, income is deferred. Therefore, when the income does arrive, it will be treated as income for the purposes of child support.
“[R]egardless of the property settlement, the disbursements [the] petitioner receives from his retirement account are income at the time they are paid.” In re Marriage of Lindman, 356 Ill. App. 3d at 469.
Deferred Compensation Plans And Maintenance In An Illinois Divorce Court
“[G]ross income” means the total of all income from all sources” 750 ILCS 505(a)(3)(A)
The tax-avoidance purpose of the deferred compensation plan will impact the net income which determines the amount of maintenance (formerly known as alimony). In Illinois maintenance “shall be calculated by taking 33 1/3% of the payor’s net annual income minus 25% of the payee’s net annual income.” 750 ILCS 5/504(b-1)(1)(A)
Of course, it might not be fair to award a spouse up to half of a deferred compensation plan and then still be required to pay that spouse maintenance from your remaining share. This could be described as “double dipping.”
“`Commentators use the phrase “double dipping” to describe the seeming injustice that occurs when property is awarded to one spouse in an equitable distribution of marital assets and is then also considered as a source of income for purposes of imposing support obligations.'”” In re Marriage of Eberhardt, 387 Ill. App. 3d 226, 232 (Ill. App. Ct. 2008)(Quoting Croak v. Bergeron, 67 Mass. App. Ct. 750, 753, 856 N.E.2d 900, 903 (2006))
While Illinois courts will entertain the “double dipping” argument, it’s hard to imagine a situation where double dipping occurs while the maintenance result does not exceed the statutory limit based on both parties’ incomes. In Illinois, maintenance, “shall not result in the payee receiving an amount that is in excess of 40% of the combined net income of the parties” 750 ILCS 5/504
If you or your spouse has a qualified deferred compensation plan and you’re getting a divorce in Illinois, you need to contact a divorce attorney who can prepare a QDRO and divide your assets accordingly. If you or your spouse has a non-qualified deferred compensation plan, you absolutely must hire an attorney who is familiar with how these plans work and what you or your spouse would be entitled to in an Illinois divorce based on the terms of that non-qualified deferred compensation plan. Specifically, you need an attorney that knows how to ask for the terms of the non-qualified deferred compensation plan in order to analyze each parties’ rights and obligations.