Throughout my military career I’ve constantly been surrounded by acronyms.  The Army is notorious for them: APFT, MOPP, PMCS, AWOL.  These are just a handful of the thousands of them that exist.  Some I know.  Most I don’t.  I was constantly having to research what the heck most of them stood for.

While acronyms were expected in the military, I didn’t imagine how prevalent they would be in the financial services industry. One of the acronyms that I came across that I felt like I was in the military again was QDRO.  What makes it even more confusing is that I’ve heard it pronounced both “Quid-dro” and “Quad-dro”.  What’s the correct pronunciation?  The jury stills out on that one.

What is a QDRO?

And exactly what does it have to do with your 401K or pension plan?  A QDRO is a Qualified Domestic Relations Order from the court which indicates the beneficiaries of your retirement account, other than you.  These beneficiaries are also called “alternate payees” and this comes into play should you and your spouse get a divorce.

Usually, the beneficiaries of your retirement account(s) might be your spouse, child or other dependent, or a former spouse, and the QDRO will define how each of these people receive distributions from the retirement account through child support or alimony payments and/or property ownership.

It’s necessary that the information in the QDRO is followed exactly in order to minimize your potential to paying penalties on money you don’t even receive from your 401k plan.

The Importance of a Qualified Domestic Relations Order

If you should go through a divorce, the QDRO becomes extremely important.  Following the QDRO is the key to avoiding 10% early withdrawal penalties imposed by 401k plans, because if you don’t follow the QDRO you can be taxed on money taken from your 401k even if it landed in the hands of your beneficiaries!  Make sure to enlist professional help (either through your 401k plan administrator or a tax professional) to minimize your own tax implications of having to distribute your 401k to alternate payees due to divorce.

Take Steps to Verify Information in the Qualified Domestic Relations Order

If your 401k plan is subject to a QDRO during a divorce (typically if you have been married at least 5 years before getting divorced), you want to give the administrator of your 401k a copy of your QDRO.  This allows them to carry out the order.  They’ll review the QDRO to ensure it’s valid within 18 months and determine whether or not any payments must be made to beneficiaries. You’ll receive notification of any alternate payee (beneficiary) receiving funds from the 401k, and provided the QDRO was followed correctly, you will not have to pay a 10% early withdrawal fee from the withdrawal of the funds distributed to your beneficiaries.

The few QDRO’s that I’ve dealt with had been drafted directly by the attorney.  All I had to was open the appropriate account (in my cases they were IRA’s) and the money was transferred directly in. I like simplicity

Who Receives Money From Your 401k After Divorce?

Where you live will determine how your 401k funds are distributed after a divorce.  Most states have equitable distribution rules, which means your 401k is divided 50/50 between you and your ex-spouse – but it depends on how long you were married and how much was contributed, as well.

Some ex-spouses win 50% of a 401k plan even in states without equitable distribution rules, during the divorce proceedings. If you live in any of the following states, you can count on paying out half of your retirement to your ex-spouse:  Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.  These are “common property” states.

For the QDRO cases I’ve worked in, all have been in the state of Illinois.  Although, not a “common property” state, each spouse did receive 50% of the retirement account balance.

What About QDRO’s and Pensions?

QDRO’s are most commonly associated to 401k’s, but while I was doing my research I learned that they can also apply to pensions.  According to the PBGC.gov website here are three items that QDRO’s must do:

1. Identity of the plan participant, each alternate payee, and each pension plan. A QDRO must specify the name and last known mailing address of the plan participant and each alternate payee covered by the order. A QDRO also must identify the name of each plan to which the order applies—this should be the plan’s formal name.
2. Amount to be paid and when payments start. A QDRO must state how much of the plan participant’s benefit is to be paid to the alternate payee, such as a dollar amount or percentage of the benefit, or make clear the manner in which the amount is to be determined. A QDRO also must specify or allow the alternate payee to choose when payments to the alternate payee will start.
3. What happens on the death of the plan participant and the alternate payee. A QDRO should specify whether the alternate payee will be treated as the participant’s spouse for purposes of any survivor benefits. A QDRO also should specify what happens to benefits when the alternate payee dies.

What a QDRO Must Not Require

There is sometimes a misconception on what a QDRO must and must not do.  The PBGC.gov site offers what a QDRO must not require the PBGC to do:

• pay any benefits not permitted under ERISA or the Code;
• provide any type or form of benefit, or any option, not otherwise provided by PBGC;
• pay benefits with a value in excess of the value of benefits that would otherwise be payable by PBGC;
• pay benefits to an alternate payee when those benefits are required to be paid to another alternate payee under an order previously determined to be a QDRO;
• pay benefits to the alternate payee for any period before PBGC receives the order;
• pay benefits as a separate interest to the alternate payee if the participant is already receiving benefit payments; or
• change the benefit form if the participant is already receiving benefit payments.

photo credit: ShellyS

A client of mine was looking to retire May of 2008. But when the market turned in the wrong direction, he decided to postpone his retirement. His 401k provider had been switched a couple years back and was not really satisfied with his current options. He was over 59 ½ and decided one day to take advantage of an in service distribution.

*Update:  You can do an in service distribution with a pension, too.

In Service Distribution- Should You or Shouldn’t You

An in service distribution allows you to rollover your vested balance from your profit sharing plan to an IRA. You will have to determine first if you are eligible. Some plans may restrict from doing so. Potential advantages may include:

• Control— Who doesn’t like control? With an IRA, you are the account owner and have more control over your assets, free from the restrictions your employer-sponsored plan can impose.
• Diversification — Many employer-sponsored plans offer limited investment options. In contrast, most IRAs typically provide a wider range of investment choices across virtually every asset class. This flexibility can help you better diversify your retirement assets to meet your individual investment goals.
• Beneficiary options — Typically, IRAs allow non-spouse beneficiaries to “stretch” an inherited IRA over their lifetimes. This type of beneficiary distribution option is not available in most employer-sponsored plans, which may limit distribution choices for your beneficiaries.

Possible Disadvantages of In Service Distributions

With every advantage there may be disadvantages. Please consider:

Age limitations — In qualified plans, the age 55 rule allows participants who stop working at age 55 or older to take distributions without the 10% IRS premature distribution penalty. In an IRA, you may not take distributions until age 59½. For this reason, if you plan to retire early, you may want to preserve penalty-free access to your retirement funds by not moving all of your 401(k) assets to an IRA before retirement.

• NUA— Net Unrealized Appreciation (NUA) tax treatment is not an option for distributions from IRAs. Therefore, if you hold highly appreciated company stock in your employer-sponsored plan, the rolling of that stock to an IRA eliminates any ability you may have to take advantage of NUA tax treatment.
• Creditor protection — While IRAs now have federal bankruptcy protection3, other IRA creditor protection is still determined by state laws. Qualified plan assets continue to have broad federal creditor protection.
  New contributions to your existing plan — Taking an in-service distribution may affect your ability to contribute to your employer-sponsored plan.
• Cost — Fees related to an IRA are disclosed in the applicable product prospectus, contract offering or other disclosure document. Typically, qualified plans do not charge fees for trading within the account, mutual fund loads or commissions. Investment expenses in a qualified plan may also be lower due to institutional pricing.
• After-tax dollars — After-tax dollars are generally segregated in a qualified plan, and can often be distributed separately. However, after-tax dollars complicate things if rolled to an IRA. If you move after-tax money into an IRA, that money becomes part of the non-deductible “basis” of the IRA and will not be separately accessible. To avoid paying tax again on your IRA “basis” when you take an IRA distribution, you must maintain careful records of the “basis” in your IRAs.

All in all, it made sense for the client in this situation. We were not able to get the proper diversification for his risk tolerance in the 401k, but could do so within his IRA.

Securities offered through LPL Financial. Member FINRA/SIPC