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It is sometimes the case that a large portion of the assets owned by married couples consist of right to payments from pension plans. In many states, like Georgia, these assets are subject to division during a divorce.
A major advantage of saving for retirement through a pension plan is that contributions from employees and employers for plans such as 401(k)’s are not taxed as income until distributed by the plan. This distribution usually occurs after retirement, at lower tax rates. However, according to provisions of the Internal Revenue Code, the assignment of pension benefits or 401(k) disbursements, including transfers to a spouse during a divorce, may result in the loss of such tax benefits.
To avoid these adverse tax consequences, the spouse who participates in the retirement plan (participant spouse) must obtain a Qualified Domestic Relations Order, commonly referred to as a QDRO. A QDRO is an order that must be entered by a Court prior to becoming effective. Additionally, the QDRO must also be approved by the administrator of each retirement plan affected.
A QDRO creates or recognizes a recipient spouse’s (referred to as an “alternate payee”) right to receive all, or a portion of, the retirement plan benefits. According to federal law concerning the division of tax deferred retirement plans, 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 or begin receiving payments at the earliest time allowed for retirement, regardless of when the participant spouse actually retires. In sum, the entry of a QDRO allows the division of tax deferred retirement plan without the recipient spouse or the participant spouse experiencing any negative tax consequences.
However, if a court orders the division of an interest in a tax deferred retirement 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 (depending on age and method of withdrawal), plus income and/or capital gains taxes on the amounts distributed to the former spouse. See our article entitled: “Retirement Assets” for further discussion on the divisibility of retirement assets upon divorce.