Divorce and retirement accounts: QDROs and IRA transfers

Retirement accounts cannot be divided the way a bank account can. Each is held in one person's name and is governed by federal tax rules and, for workplace plans, federal pension law. Dividing one outside those rules can turn a transfer into a taxable withdrawal.

Two sets of rules

State law decides how property is divided in a divorce, and those rules vary. Federal law decides how the division of a retirement account is carried out.

A divorce decree that simply says "the 401(k) will be split equally" is generally not enough for a plan to act. The plan needs an order that meets the QDRO requirements.

What a QDRO is

The IRS defines a QDRO as a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant. The person who receives the payment is called the alternate payee.

According to the IRS, the order must contain specific information, including:

• the name and last known mailing address of the participant and of each alternate payee, and
• the amount or percentage of the participant's benefits to be paid to each alternate payee.

A QDRO also may not award an amount or a form of benefit that the plan does not offer.

In practice, the order is approved by the court and then reviewed by the plan administrator, who decides whether it qualifies, and the plan generally does not pay under it until then. Some plans provide model language. The Department of Labor publishes guidance on QDROs for participants and former spouses.

How QDRO payments are taxed

The IRS describes three main tax rules.

A spouse or former spouse is taxed as if they were the participant. Payments they receive under a QDRO are reported on their own return.

A spouse or former spouse can roll the money over. The IRS states that a spouse or former spouse who receives a QDRO distribution can roll it over tax-free, just as the employee could. A direct rollover to the recipient's own IRA postpones tax until the money is withdrawn. See how a 401(k) rollover works.

Payments to a child or other dependent are taxed to the participant, not to the child.

There is also a notable exception to the early withdrawal rules. Distributions from a workplace plan to an alternate payee under a QDRO are on the IRS list of exceptions to the 10% additional tax on early distributions. The exception does not apply to IRAs, so once QDRO money has been rolled into an IRA, a later withdrawal before age 59½ follows the usual IRA rules.

A hypothetical example: a QDRO awards a 45-year-old former spouse $100,000 from a 401(k). If the full amount is sent by direct rollover to an IRA, no tax is due at that time. If the former spouse instead takes $20,000 in cash from the plan and rolls over $80,000, the $20,000 is taxable income for the year but is not subject to the 10% additional tax.

Dividing an IRA

IRAs are not covered by the QDRO rules. IRS Publication 504 explains that transferring all or part of an interest in an IRA to a spouse or former spouse, under a decree of divorce or separate maintenance or a written instrument incident to the decree, is not considered a taxable transfer. From the date of the transfer, the transferred portion is treated as the receiving spouse's own IRA.

The order of events matters. A transfer made directly from one spouse's IRA to an IRA in the other spouse's name, under the decree, follows this rule. If the account owner instead withdraws the money and hands it over, the withdrawal is generally taxable to the owner, and the early distribution tax may apply.

After the transfer, the receiving spouse is responsible for the tax on future withdrawals.

Pensions, survivor benefits and after-tax value

A traditional pension can also be divided by QDRO, typically by assigning the former spouse a share of each monthly payment or a separate benefit of their own.

Survivor rights are a separate question from the split of payments. The IRS notes that a QDRO can require a former spouse to be treated as the surviving spouse for purposes of a plan's survivor annuity. Without such a provision, a former spouse's share of a pension may end when the participant dies.

Dollar amounts in different kinds of accounts are also not equivalent. Withdrawals from a traditional 401(k) or IRA are generally taxable, and qualified withdrawals from a Roth account are generally not, so $100,000 in one may not equal $100,000 in another after tax. See taxable, tax-deferred and tax-free accounts.

After the divorce is final

• Beneficiary designations. Retirement accounts and life insurance pay whoever is named on the beneficiary form. The IRS advises a divorced participant who wants to change the beneficiary of survivor benefits not covered by a QDRO to contact the plan administrator. See beneficiary designations.
• Social Security. Benefits based on a former spouse's work record are set by federal law and are not divided by the divorce court. See spousal and survivor benefits.

Questions worth asking along the way include which accounts are employer plans and which are IRAs, whether each plan has a model QDRO, and how the order treats investment gains or losses between the valuation date and the transfer.

Property division is governed by state law and the tax results depend on individual circumstances, so an attorney or tax professional can advise on the specifics of a particular divorce.