In the United States, the reality for spouses is that nearly half of all marriages end in divorce. As a result, many people go through divorce proceedings, which can create a QDRO account given certain circumstances. But, what exactly is a QDRO, and how does it operate?
What is a QDRO account?
A QDRO account is an employer-sponsored retirement plan partitioned and rewarded to an alternate payee, such as an ex-spouse. QDROs emanate from Qualified Domestic Relations Orders issued by a court and typically are the product of divorce proceedings.
When a court issues a QDRO ruling, the judge confirms that an ex-spouse is entitled to a portion of the other partner’s ERISA-governed defined contribution or defined benefit retirement plan(s).
The court must declare a percentage or dollar amount the ex-spouse will receive when issued. Such orders are commonplace since courts must divide marital assets appropriately, and employer-sponsored retirement plans are complicated legal entities.
Consequently, QDROs homogenize the division process and allow retirement plan administrators to satisfy relevant judicial instructions.
While ex-spouses generally are the recipients of QDRO accounts, minors or other dependents can be the beneficiary, depending on the case.
Recipients of QDRO monies do not pay taxes upon receipt of the account. Instead, taxes become due when any personal withdrawal occurs.
QDROs are regularly created from 401(k) plans since they are more frequent than other retirement accounts nowadays. Still, most pensions are subject to QDRO decrees, as are some (non-governmental/non-religious) 403(b) plans.
What retirement accounts require a QDRO?
QDROs can only originate from employer-sponsored retirement plans that a magistrate divides, meaning that traditional and rollover IRAs, plus state-managed plans like CalSavers (and likely Colorado’s Secure Savings), are governed by other legal mandates and mechanisms.
Four characteristics of QDRO accounts
Can I withdraw money from a QDRO?
When receiving a QDRO plan, a recipient may withdraw from it at any time without penalty, regardless of age.
Yes, you read that right: the standard age 59.5 requirement for retirement plan distributions does not apply to QDROs. (To learn about other retirement plan withdrawal exemptions not subject to the pesky 10% IRS fee, I suggest reading How To Withdraw From IRA & 401k Plans Without Penalty.)
Unlike IRA plans that allow investment flexibility and withdrawals on demand, QDRO accounts are subject to a particular retirement plan’s investment offerings and rules. For example, if a 401(k) program states that QDRO accounts allow for one-time distributions, QDRO recipients have no choice and must oblige by removing all funds during their first and only withdrawal.
In my personal experience as a former 401(k) and 403(b) advisor, many QDROs provide investment and withdrawal flexibility. Still, some plans are onerous and may encourage the immediate withdrawal of funds. Fortunately, QDRO plans are (generally) eligible for rolling over into one’s IRA or other personal workplace retirement accounts.
Withdraws & Taxes
Any QDRO funds withdrawn from and not redeposited into another qualified retirement plan receive tax designation as ordinary income; an exclusion applies to Roth monies and NUA* gains. These taxable distributions of QDRO funds are subject to a mandatory 20% tax withholding enacted by the IRS for all defined contribution retirement plan participants.**
To learn more about 401(k) and 403(b) oddities that apply to QDROs, you can reference Left your job or old 401(k): Now what?
*NUA stands for net unrealized appreciation, an attractive yet complex tax opportunity for company stock held in a 401(k) or ESOP plan.
**The 20% withholding requirement is waived for RMD withdrawals that must begin at age 72. RMD stands for required minimum distribution, which I explain further in my Left your job or old 401(k) article.
Plan Administrators can reject QDRO rulings
While unlikely, plan administrators can reject a QDRO ruling if it conflicts with plan rules. I suggest working with an attorney seasoned in qualified domestic relations order rulings to avoid rejection.
Rejections arise because ERISA-governed plans are distinct legal entities that cannot execute something in contradiction to their relevant governing documents.
If a rejection occurs, the parties and their legal counsels must work with the court to resolve the denial. Once the redrafting of the legal document occurs to ensure plan compliance, the justice of the court must reissue the QDRO order.
QDROs can go down in value after awarding!
Note that QDROs can, and do, go down in value since the holdings awarded remain invested as the original account holder selected until received by the new alternate payee/beneficiary.
I saw this first hand in my previous job as a 401(k) advisor. It can be a flustering experience for a recipient if they are unaware of the QDRO process since they had counted on receiving a different amount.
I encourage QDRO recipients to reinvest their holdings once the account becomes accessible. Just because the investments were appropriate for one’s ex-spouse does not mean they are suitable for the new payee.
Suppose you are unsure how to construct a portfolio and have received a QDRO account. In that case, I encourage reading What Is Risk? Baby Don’t Hurt Me, No More! In this article, I discuss the basics of investing according to one’s risk tolerance.
Final thoughts on QDROs
QDROs are unusual retirement accounts that provide ex-spouses and dependents access to a nest egg or savings that can help them transition to a new life.
While divorce is not a fun process, it can be amicable. Through QDRO rulings, courts weigh each individual’s monetary and non-monetary contributions to the marriage/household. Then, once issued, the judiciary system facilitates the division of wealth accumulated during marriage to ensure fairness.
I hope you have found today’s post informative. If you have questions about QDRO accounts or want to share your experiences with them, please chime in using the comments section below.
Until next time, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time