Divorce and related taxes are actually simple.
Now, this may be an unexpected opening to a lengthy column in a professional journal. Here is the explanation: "Simple" is not the same as "easy." Divorce and taxes are in fact simple--as long as you do everything right. And that second part is not easy. This author has seen divorcing couples make mistakes that have cost them thousands of dollars in taxes, usually because they thought they knew what they were doing. Others have paid the price for missing a small bit of instructions or a detail that seemed irrelevant to them at the time.
CPAs are in a unique position to add value by guiding clients around potential pitfalls on the tax side of life. Unfortunately, divorce is a reality that some clients will have to face. This column should serve as a helpful blueprint for avoiding expensive mistakes.
Trap No. 1: Creative treatment of the QDRO for qualified defined benefit plan accounts
It would be helpful to first review the definitions of a few key terms.
A qualified domestic relations order (QDRO) is a vehicle for transferring certain retirement funds from one spouse to another in a divorce. Think of it as a court order that directs and authorizes the plan administrator of a qualified retirement plan to present to the alternate payee the dollar amount or the percentage of a participant's qualified retirement plan account balance.
It is important to remember that, in theory, the alternate payee's funds could remain in a separate account inside the plan for which the QDRO was written. The payee could then take distributions in the future without incurring any taxable income or penalty. The author has yet to encounter a qualified retirement plan administrator that allows an alternate payee to have such an account in the plan. The author usually recommends that spouses execute the QDRO and move the funds to another retirement savings account established for the alternate payee.
Consider the following key points about QDROs:
* Before any funds are released to the alternate payee, the plan administrator must have approved the court-ordered QDRO. Most divorcing couples assume that the finds will become available as soon as they sign the divorce agreement--this is not the case. If the money is directed into a tax-deferred retirement savings account, the delay is not a problem. However, if a client has immediate plans for those funds (such as covering living expenses while searching for a job), he or she needs a bridge to work with the timing of the plan sponsor's QDRO approval process.
* QDROs can only be used to divide qualified retirement accounts governed by ERISA such as 401(k) and 403(b) accounts, but not IRAs. While a QDRO may be used to divide defined benefit plans, the procedure explained here applies only to plans that allow a lump-sum distribution such as a defined contribution account.
* Military retirement plans do not use QDROs and, as such, are not covered here.
When executed carefully, QDROs work exactly as intended and keep the transfer of assets a nontaxable transaction. A QDRO is drafted, approved by the court, signed by the judge, and approved by the plan administrator. The funds that have been awarded to the nonparticipant spouse (the alternate payee) are transferred into a tax-deferred retirement account, such as an...