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What do ERISA, QDROs and taxes have in common?

The one word that ties these three together is divorce. If you participate in your employer's retirement plan, then you know that withdrawing any funds early means a hefty tax penalty, usually 10%. When you started contributing to your plan, you probably didn't anticipate making any early withdrawals.

Now that you are getting a divorce, your spouse has the right to a certain percentage or amount of your retirement plan. It appears as though you will end up making an early withdrawal after all. Is there a way around paying the tax penalty? Will you owe taxes on the distribution amount?

You need a qualified domestic relations order

If your retirement account falls under the Employee Retirement Income Security Act of 1974, or ERISA, then you will need a qualified domestic relations order signed by the Virginia judge presiding over your case. Under ERISA rules, your plan's administrator will not make a distribution to anyone other than you without a QDRO because you cannot give anyone a stake in your plan without it. This order allows the distribution ordered in your divorce to happen and without the tax penalties ordinarily associated with an early withdrawal.

You get the following benefits from a QDRO

Giving up a portion of your retirement plan was probably not in your plans, but if your future former spouse will not trade another asset for a portion of it, then you may not have a choice. However, just because you are losing part of the funds in your retirement account does not mean you don't get something for doing so. In addition to not having to pay the tax penalty for the withdrawal, you also receive the following under the QDRO:

  • Your former spouse can receive death benefits from your retirement plan, so you don't have to worry about providing for your ex otherwise.
  • Your ex-spouse pays the taxes on any distributions he or she takes -- not you.
  • The withdrawals made by your ex-spouse are income for him or her as far as the IRS is concerned.

To state it plainly, you are not responsible for any taxes associated with the distribution you must make from your retirement plan to your former spouse as part of the divorce.

You need to do it right, though

It may sound easy enough, but you could easily make a mistake and undo what you were trying to do if you fail to make sure the order is properly constructed. The law requires specific information in a QDRO, and without it, the IRS and/or a court could rule it invalid. Moreover, your plan's administrator may have certain requirements as well in order to honor the QDRO.

It would be worthwhile to make sure your QDRO makes everyone happy and passes every test, especially if you have a substantial amount of money in your retirement account and will end up giving up an appreciable portion of it.

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