Lawyers love to use acronyms and buzzwords to shorten long phrases like “Qualified Domestic Relations Order” which is commonly referred to as a “QDRO.” So, what is a QDRO, exactly, in an Illinois divorce?
QDROs are court orders that allow for 1) the division of a tax-deferred retirement account and 2) the preservation of that account’s tax-deferred status.
What Is A Tax Deferred Retirement Plan
Almost all retirement plans and accounts in the United States are tax deferred. A tax-deferred plan is an investment account that allows taxpayers to postpone paying taxes on the money invested until it is withdrawn, generally after retirement. These accounts are commonly referred to based on the tax code which gives them their tax-deferred status: 401(k), 457(b), IRA.
So, if a worker is putting 10% of his gross income into a 401k or other tax deferred retirement plan, that worker will only pay income taxes on the other 90% of his income.
When that worker finally withdraws money from the 401k plan, the worker will have to finally pay income taxes on the amount withdrawn.
The advantage of having tax deferred savings is as follows. Investments grow exponentially with compound interest, so it is better to pay taxes later than now. This is best illustrated by the following example.
$13,333 saved growing at 5% annually will be $57,626 after 30 years. After paying 25% taxes the saver will take home $43,219
If the 24% taxes were taken out first on that $ 13,333 the math would be as follows. $13,333 less 25% is $ 10,000. Compounded at 5% after 30 years is $ 30,175.
So, in order to take home the most money possible it’s extremely advantageous to save that money in a tax-deferred account like a 401(k), IRA or 403(b) account.
Furthermore, tax-deferred retirement accounts are not seizable in a bankruptcy. Patterson v. Shumate, 504 U.S. 753 (1992)
These plans are designed this way to encourage workers to save for retirement. In addition to the benefits of saving in a tax-deferred plan, there are penalties for early withdrawals.
What Happens if You Withdraw Money From A Tax Deferred Plan?
In order to encourage savings and not have people treat their retirement accounts like a checking account, there are penalties for early withdrawals.
When a person withdraws money from a tax-deferred plan, both the initial investment and the gains the plan earned are taxed at your income tax rate in the year you withdraw it. Usually people’s prime earning years are in their 40s and 50s, so the income tax rates will be higher for withdrawals during those years. Also, the withdrawal will count as additional income, potentially raising the income tax rate.
However, if the tax-deferred money is withdrawn money before the plan participant reaches age 59½, there will be an additional assessed a 10% penalty on top of the regular income tax based on the person’s tax bracket.
Making sure these withdrawal penalties don’t kick in when dividing and distributing tax-deferred accounts is the duty of any Illinois divorce lawyer.
Splitting Up A Tax Deferred Retirement Plan In An Illinois Divorce
Any property that is marital property can and will be divided or allocated in an Illinois divorce.
“‘[M]arital property’ means all property, including debts and other obligations, acquired by either spouse subsequent to the marriage” 750 ILCS 5/503(a)
“For purposes of distribution of property, all property acquired by either spouse after the marriage and before a judgment of dissolution of marriage or declaration of invalidity of marriage is presumed marital property.” 750 ILCS 5/503(b)
So, any retirement plan that either spouse contributed to will be considered marital property in an Illinois divorce (proportionate to non-marital contributions but we’ll get to that later).
Pension plans don’t seem like an asset because you can’t see a balance on a statement. But pension plans in Illinois are treated as retirement plans divisible by QDRO. “Pension benefits earned during the marriage are considered marital property and, upon dissolution, are subject to division like any other property.” In re Marriage of Menken, 334 Ill.App.3d 531, 533
“[I]n many cases pension benefits may constitute one of the most important items of property acquired in a marriage of long duration; in some perhaps, it may be the only asset of any significant value.” Smithberg v. Illinois Municipal Retirement Fund, 192 Ill. 291, 304 (2000)
Dividing a tax-deferred plan requires that the account stay tax-deferred as to both parties. Otherwise, penalties will incur upon division and distribution.
One of the final documents in an Illinois divorce is the Marital Settlement Agreement. The Marital Settlement Agreement will instruct the parties to the divorce on how to divide a tax-deferred retirement account.
The language typically looks like this: ”50% of the marital portion of BOB’s Fidelity 401(k), divided by a Qualified Domestic Relations Order (“QDRO”) upon entry of the Judgment for Dissolution of Marriage”
As you can see, that is not a lot of detail about how the funds will be distributed and how the parties will insure that tax penalties will not occur. That’s because all of those details are included in the Qualified Domestic Relations Order.
Sometimes the Qualified Domestic Relations Order is entered at the same time as the final Judgment of Dissolution of Marriage. Sometimes the Qualified Domestic Relations Order is entered months later when the dust settles (sometimes, they are entered by different lawyers).
What Is A Qualified Domestic Relations Order?
The taxes that are being deferred in a tax-deferred account are federal taxes. So, federal law determines how a divided tax-deferred account will stay divided.
“The term “qualified domestic relations order” means a domestic relations order—
which 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 payable with respect to a participant under a plan” 26 U.S. Code § 414(p)(1)(a), ERISA § 206(d)(3)(B)(i)
The federal statutes go on to list what must be included in a Qualified Domestic Relations Order.
“(A) the name and the last known mailing address (if any) of the participant and the name and mailing address of each alternate payee covered by the order,
(B) the amount or percentage of the participant’s benefits to be paid by the plan to each such alternate payee, or the manner in which such amount or percentage is to be determined,
(C) the number of payments or period to which such order applies, and
(D) each plan to which such order applies.” 26 U.S. Code § 414(p)(2), ERISA § 206(d)(3)(C)
The federal statute then lists what a Qualified Domestic Relations Order must NOT do.
“(A) does not require a plan to provide any type or form of benefit, or any option, not otherwise provided under the plan,
(B) does not require the plan to provide increased benefits (determined on the basis of actuarial value), and
(C) does not require the payment of benefits to an alternate payee which are required to be paid to another alternate payee under another order previously determined to be a qualified domestic relations order.” 26 U.S. Code § 414(p)(3), ERISA § 206(d)(3)(D)
This is a lot to keep track of! Luckily, 99% of tax-deferred plans have a model QDRO for divorce lawyers to use. In fact, the law requires them to.
“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)
A friendly call to any customer service number on your 401k or pension statement will direct you to a sample Qualified Domestic Relations Order “QDRO.”
Marital vs. Non-Marital Portions of Tax-Deferred Accounts.
If a tax-deferred account was started during the marriage, that account will be entirely marital and the account can therefore be divided 50/50 between the parties.
“For 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)
If the tax-deferred account was started before the marriage, the contributions made to that account before the marriage are non-marital.
Non-marital assets are not divisible in an Illinois divorce.
[T]he court shall assign each spouse’s non-marital property to that spouse.” 750 ILCS 5/503(d)
“A spouse may overcome the presumption that…pension benefits are marital property by showing through clear and convincing evidence that the pension benefits were acquired by [proving they had a non-marital nature]” 750 ILCS 5/503(b)(2)
You don’t have to. The company that holds the tax-deferred retirement account or pension will do it for you.
The sample QDRO always includes a way to divided the marital portion of the tax-deferred account. The QDRO asks for the marriage date and the divorce date. Using those dates, the company will calculate and divide the tax-deferred plan correctly.
How do you know the company calculated the marital portion correctly?
You can hire your own actuary if you’d like…but no one really does that.
Presumably if a company was calculating your marital portion wrong they’d be calculating everyone else’s portion wrong. This gross malfeasance would be exposed to class action law suits that could easily be proven.
Entering A Qualified Domestic Relations Order In An Illinois Divorce Court
Most Qualified Domestic Relations Orders require the signatures of both parties. This makes an executed QDRO an agreed order.
Illinois divorce judges typically accept agreed orders without needing a motion. Simply walk into court or email the agreed QDRO to the judge’s clerk for entry.
Most tax-deferred plan administrators require a signed copy of the QDRO. Typically, the judge only signs one copy of an order so you’ll need to remind the judge to sign two copies. One for the file and one for the plan administrator.
What Happens After The Qualified Domestic Relations Order Is Entered In An Illinois Divorce Court?
After the QDRO is entered and mailed to the plan administrator, the plan administrator executes the instructions on the QDRO and effectively creates another tax-deferred plan for the assigned spouse.
“[T]he plan administrator shall promptly notify the participant and each alternate payee of the receipt of such order and the plan’s procedures for determining the qualified status of domestic relations orders, and… and notify the participant and each alternate payee of such determination.” 26 U.S. Code § 414(p)(6)
The spouse, “alternate payee” shall then be treated as though they worked for the same company as they will now have a retirement plan with that company based on their former spouse’s employment.
Alternatives to Qualified Domestic Relations Orders In An Illinois Divorce?
Not every retirement plan needs to be divided during an Illinois divorce.
Individual Retirement Accounts (IRAs) are not qualified retirement accounts. Therefore, IRAs do not need to be divided by a QDRO.
“The transfer of an individual’s interest in an individual retirement account or an individual retirement annuity to his spouse or former spouse under a divorce or separation instrument described in clause (i) of section 121(d)(3)(C) is not to be considered a taxable transfer made by such individual notwithstanding any other provision of this subtitle, and such interest at the time of the transfer is to be treated as an individual retirement account of such spouse, and not of such individual. Thereafter such account or annuity for purposes of this subtitle is to be treated as maintained for the benefit of such spouse.” 26 U.S. Code § 408(d)(6)
Additionally, the value of a qualified retirement plan will typically go up and down with the stock market. So, a divorce may start in one year and end the next year with the retirement plan being worth 50% more (or less). This is a lot of volatility for someone who’s finances are already being rocked by a divorce.
Instead of dividing a retirement plan, the parties can assign other property of approximately equal value. The most common division is one party keeps the retirement plan while the other party keeps the marital home.
This will never be an exact split due to the volatility of a retirement plan. But, if the difference is extreme (more than $ 10,000) an equalizer payment may be agreed to.
The parties must remember that a tax-deferred retirement plan is not worth what the balance statement says. The taxes still have yet to be paid against the balance as income!
So, a discount of 20 to 30% should be applied to tax-deferred accounts when calculating equivalent values of divided marital assets.
If you’d like to learn more about how to divide your retirement funds during divorce without incurring tax penalties, contact my Chicago, Illinois family law firm to schedule an appointment with an experienced Chicago divorce lawyer.