Divorce is one of those events in life that is an unpleasant topic at best. Between the emotions, property issues, and custody issues, the pain is often excruciating, but don’t let that keep you from fully protecting your financial life.

Recently, a friend went through a divorce and, as part of the property settlement, received one-half of her ex-husband’s retirement account. Without giving any real thought, she immediately rolled the payment into an IRA. After all, she thought, isn’t that what she needed to do to avoid taxes?

Several months later, she realized that she needed to withdraw the money from the IRA to pay for a place to live. The catch was that she was under 55 years old and therefore had to pay a 10% penalty on her withdrawal. Had the divorce decree been properly drafted, and had she not first placed the money in an IRA, she could have saved herself about $5,000.

When spouses are divorced, and one spouse receives a portion of the other’s retirement account under a Qualified Domestic Relations Order (QDRO), the funds received do not have to be rolled into an IRA or other qualified account in order to avoid a ten percent penalty for early withdrawal. Yes, any funds not rolled over will be subject to income tax, but not the early withdrawal penalty.

A QDRO is a judgment or order (including the approval of a property settlement) issued by a state court that pertains to the provision of child support, alimony, or other property rights in a retirement plan participant’s account. In order for it to be effective, it must be made under a court order. If the parties to a divorce agree to a property settlement, but do not get court approval, then any subsequent payment made pursuant to the agreement does not qualify as a QDRO.

A QDRO must include the following:

• The name and last known mailing address of the participant spouse and each alternate payee (the person to receive the distribution pursuant to the order);
• The name of each plan to which the order applies;
• The dollar amount, percentage or method of determining the amount or percentage, to be distributed to the alternate payee; and
• The number of payments to be made.

A QDRO cannot:

• Require payment options not already allowed under the plan to which the QDRO applies;
• Require a plan to pay increased benefits on the basis of actuarial value;
• Require a plan to pay benefits to an alternate payee that are already required to be paid to another alternate payee under an existing QDRO;
• Require that the plan pay benefits in the form of a qualified joint and survivor annuity based on the life of the alternate payee and his or her subsequent spouse.

As you can see, there are a number of technical questions and issues that must be addressed in order for a QDRO to qualify under applicable retirement and federal tax rules. It is therefore important to use competent advisors in the drafting and execution processes. Since the administrator of a retirement plan is the ultimate judge of whether the plan qualifies, make sure you and your advisors meet the administrator’s requirements to minimize any delay in receiving your funds.

Assuming your property settlement will qualify under the QDRO rules, it is important to make sure you use the distribution wisely. Take some time to review the tax consequences of any rollover before committing your money. If you have any questions, please feel free to give us a call. Running the numbers and spending a little time on planning can pay big dividends in the future.

Enjoy your Memorial Day weekend.