Divorce and Retirement Plan Proceeds: A Case Study
It is rarely pleasant to discuss divorce, yet it is an unfortunate occurrence that happens with increasing frequency in our society. Because divorce involves the dividing of assets, some of which have tax implications, it is important to be aware of the “tax traps” that may be lurking. As more Americans participate in 401(k) plans and other defined contribution retirement plans, dividing vested retirement plan assets in divorce situations has created complex financial issues.
A True Case History
In 1987, a New Mexico orthodontist (Dr. Arthur Hawkins) agreed to give his wife (Glenda) $1,000,000 from his retirement plan as part of their divorce agreement. He assumed Glenda would be responsible for paying taxes on the money since she would eventually have control of it. After all, he wasn’t taking money out of the plan. . .or so he thought. Neither he nor Mrs. Hawkins reported the distribution on their separate 1987 tax returns.
In 1989, the Internal Revenue Service (IRS) demanded that both parties include the distribution on their separate 1987 tax returns, prompting each to petition the Tax Court for a ruling. In A. Hawkins, 102 TC 61, Dec. 49,638, the Tax Court ruled that the divorce agreement was not a qualified domestic relations order (QDRO), leaving Dr. Hawkins with a Federal income tax bill of almost $400,000, while his ex-wife received $1 million tax free.
Fairness would seem to dictate that the spouse receiving the money would pay the tax on it, and that may have been the case had the taxpayer filed a QDRO as part of the divorce decree.
A QDRO is a judgment, decree or order that is made pursuant to state domestic relations law that relates to child support, alimony, or property rights pertaining to a spouse, former spouse, child, or other dependent, referred to as the “alternate payee.” A QDRO creates or recognizes the existence of the alternate payee’s right to receive all or a portion of the benefits payable to a participant under a retirement plan. If properly drafted, the QDRO can ensure that the alternate payee pays the taxes on benefits awarded to him or her.
To be protected through a QDRO, it must specify:
• The name and address of the plan participant and the “alternate payee” (typically, the participant’s spouse).
• The name of each plan to which the order applies.
• The percentage (or dollar amount) of the benefit to be paid to the alternate payee.
• The period of time, or the number of payments, to which the QDRO applies.
The QDRO must go in the divorce decree or court-approved property settlement document. The decree should also specify that a QDRO is being established under Section 414(p) of the Internal Revenue Code and the particular state’s domestic relations laws. Intent to establish a QDRO is insufficient; it must be spelled out in the divorce papers.
In Hawkins, it was the position of the Tax Court that the divorce agreement was not clear enough to recognize or assign rights to the former wife as an alternate payee to benefits payable under the plan because it did not contain a reference to Section 414(p).
On Second Thought...
Dr. Hawkins appealed the Tax Court decision and received a favorable ruling in 1996 (Hawkins v. Comm., 86F.3d982, 10th Cir. 1996) in which the 10th Circuit Court maintained that the Tax Court’s reading of the Section 414(p) requirements was too narrow. Specifically, the Appeals Court held that the exact wording of Section 414(p) did not have to be present in the decree in order for the QDRO requirements to be met.
Getting divorced can be “taxing” enough, but it need not be made more difficult by poor drafting of a QDRO. And, although the decision in Hawkins allows a certain amount of latitude in the language used to draft a QDRO, applying the proper language in a divorce decree may ease some of the inevitable complications that can arise when dividing retirement plan assets. At a minimum, qualified legal advice should be obtained to ensure that any desired planning actions are properly worded and structured.
The information contained in this article is for general use and while we believe all in formation to be reliable and accurate, it is important to remember individual situations may be entirely different. Therefore, information should be relied upon only when coordinated with professional tax and financial advice. Neither the information presented nor any opinion expressed constitutes a representation by us or a solicitation of the purchase or sale of any insurance or securities products and services. Written and published by Liberty Publishing, Inc. Copyright © 2013 Liberty Publishing, Inc. RPTQDRO2-04
The information provided is not written or intended as specific tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. MassMutual, its employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.
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