Qualified domestic relations and similar orders frequently create confusion for divorce practitioners. The reasons for this are many, but the confusion commonly stems from the reconciliation of state and federal law, that QDROs are financially intensive, and that each plan is different.
The following practice management tips are intended to aid in demystifying some often overlooked QDRO matters while giving you additional tools to turn to when you are advising your clients.
1. Distribution Timing. The plan document will determine when distributions can be made from the plan, and neither the settlement agreement nor the state court can modify these timelines. Some of the most common events that will enable your client to take a distribution include reaching age 59.5, a termination of employment, entering retirement, experiencing a specified hardship, or pursuant to a domestic relations order. Therefore, when you advise your client on when they may anticipate a reduction in their account value (dc plan participant) or receive a payment (alternate payee) after a QDRO is entered, do not state that any action will happen immediately. Also, do not specify a date or age in the settlement agreement that a transfer must take effect by or, at minimum, you may find yourself with a disappointed client, if not a malpractice claim.
2. Distribution Forms. The plan document also determines the type of distributions that are available under the plan. Retirement benefit payments usually take the form of either a lump sum or an annuity. A lump-sum is a singular payout, whereas an annuity provides installment payments over a specified period. Common annuity payment methods include life-only, joint and survivor, or life with period certain.
Please note, defined benefit plans typically pay out a monthly annuity to the participant during retirement. If you notice a lump-sum associated with a defined benefit plan, it may be a present value calculation intended to provide the practitioner with a number to use to offset the value of the retirement plan benefit with other marital property. Defined benefit plans do not usually make lump-sum payments. If the settlement agreement calls for a lump-sum payment to be provided to an alternate payee when addressing a defined benefit plan, the agreement will, at minimum, need to be compared to the plan provisions to assess the availability of the proposed action and possibly modified to conform with the terms of the plan or you run the risk of the alternate payee not receiving their share of benefits.
In other words, it is prudent to be aware of the distribution options that are available under the plan before finalizing your settlement agreement.
3. Lump-Sum Values. Lump-sum values may be used when dividing defined contribution plans. This is true whether you use a fixed-dollar, percentage, or a combination to award the alternate payee with their share of the marital assets or for purposes of paying child support or alimony. However, you should be aware that just because a lump-sum is awarded does not mean that this is the amount that the alternate payee will ultimately receive. This is because there is a time gap from when the divorce decree is finalized to when the plan administrator approves the final QDRO and pays out or segregates the participant’s account from the alternate payee’s account. During this time, there will be market fluctuations based on how the account is invested. Therefore, by the time the alternate payee can receive or rollover their share, the value of the lump-sum award may be more or less than originally expected due to investment gains or losses. Further, retirement plan distributions are subject to a mandatory 20% withholding for federal taxes. Therefore, it is suggested that you advise your client accordingly, so their expectations are adequately managed as they pertain to the amount of money they may receive in the settlement.
4. Investment Management (DC plans). Typically, when a plan administrator separates the plan participant and alternate payee accounts, the alternate payee will receive a proportional share of the underlying securities in the plan participant’s account. There is nothing inherently wrong with this approach; however, the alternate payee should be advised that they have the right to modify the asset allocation to align with their own financial objectives, risk tolerance, time horizon, or level of investing experience. That is, if the alternate payee decides to keep their account with the employer or there is a time gap before the alternate payee can roll the funds over to another account. If the alternate payee wants to change the investment mix on their portion of the account, they should contact the plan administrator to obtain the appropriate documentation to effectuate the changes.
If a flat-dollar award is used, you may want to require the plan participant to keep the flat-dollar amount in cash or some other low-risk investment available under the plan until the assets become available for distribution. Alternatively, you can make the valuation date for plan division the date that the plan administrator separates the plan participant and alternate payee accounts or the latest date allowable under the plan. Either of these alternatives will help ensure that the funds remain available to the alternate payee when the QDRO is finished being processed by the plan administrator.
5. Corrective Action. On occasion, a plan may send a payment to the wrong party. It is common for a settlement agreement, or even a QDRO, to have a provision that requires the wrongful recipient spouse to act as trustee for the benefit of the other spouse and pay the other spouse the amount they received in error. The order may even go on to require that the wrongful recipient spouse indemnify the other spouse for income tax purposes. Although these provisions may provide the parties with clarity, they are not binding on the IRS or state revenue departments. Therefore, the wrongful recipient spouse may still have a tax liability for receiving the money unless there is a corrective action. The best practice for curing this scenario is for the wrongful recipient spouse to return the payment to the plan so the error can be remedied and the potential tax issue can be resolved.
6. Default Plan Provisions. If an order is silent on a matter, the plan will either reject the order or implement its default provisions. The guidance for how a plan will interpret ambiguities or silence can be found in the plan documents or QDRO procedures. It is important that you understand how the plan will operate under these circumstances, so you do not inadvertently award or restrict benefits not contemplated and negotiated by the parties because of the silence.
Hopefully, these QDRO practice management tips will be useful the next time you are faced with dividing a retirement plan in your practice.