Joel M. Blau, CFP, and Ronald J. Paprocki, JD, CFP, CHBC, discuss the importance of qualified domestic relations order language in a divorce settlement, as well as what qualifies as a withdrawal from a retirement plan.
Physicians are right there among the increasing number of Americans impacted by divorce each year. While there are many non-financial issues to consider when going through a divorce, financial implications must be examined.
For a vast majority of physicians, tax-qualified retirement plans represent their family’s largest financial asset. It is for this reason that retirement plans are often used for asset splits among divorcing couples. Examples of qualified retirement plans include your practice’s profit-sharing plan, pension account, or 401(k) plan. Solo practitioners may also have substantial assets in a Keogh or SEP (Simplified Employer Pension) retirement account.
In a divorce, the account will probably be divided between you and your soon-to-be-ex-spouse as part of the property settlement. While, of course, the majority of the time will be spent agreeing to the percentages going to each spouse, making the split in the wrong way can create a real tax problem. This situation has proved very confusing to divorcing couples due to the inherent income tax and early withdrawal penalties associated with such accounts. Much of the confusion, however, is related to misinformation or simply a lack of understanding relative to the complex nature of the tax law as it relates to qualified plans.
Ronald J. Paprocki, JD, CFP, CHBCThe bottom line is that in order to divide qualified retirement plan accounts in the most tax-efficient manner, be sure to utilize a qualified domestic relations order (QDRO). This document involves some very important language that should be included in the divorce paperwork, especially if there are substantial retirement assets.
First and foremost, the QDRO establishes your ex-spouse's legal right to receive a designated percentage of your retirement account balance or certain retirement benefit payments. More importantly, the QDRO ensures that your ex-spouse, not you, will be responsible for the related income taxes when he or she takes retirement account withdrawals.
The QDRO arrangement also permits your ex-spouse to withdraw the designated share of the retirement account money and roll it over into his or her own IRA (assuming such a withdrawal is permitted by the terms of the qualified retirement plan in question). By utilizing a tax-qualified rollover, your ex-spouse can take over management of the designated share of the retirement account money and avoid a 10% early withdrawal penalty (if under age 59½), while postponing income taxes until he or she begins taking withdrawals from the IRA. So taken as a whole, a QDRO is a seemingly unique and straightforward fair arrangement for both parties.
NEXT: What happens without a QDRO?
So what happens without a QDRO? If money from your qualified retirement plan account gets into your ex-spouse's possession without a QDRO in place, you face a disastrous tax outcome. Specifically, you're treated as if you received a taxable distribution from the retirement account and then turned over the resulting cash to your ex-spouse. So you owe all the tax while your ex-spouse gets the money tax-free.
Also see - IRA beneficiaries: Know who receives what
To add insult to injury, you could also be liable for the 10% early withdrawal penalty tax if the distribution occurs when you are younger than age 59½. There really is no reason for this to happen if you take the time to proactively plan prior to the time the assets are split.
As you can see, it's critically important to get proper QDRO language into your divorce papers before signing off on the property settlement. Your attorney should be well aware of this tax savings strategy utilized by divorcing couples, but if not, be sure to inquire about the feasibility of using a QDRO for your own personal situation.
NEXT: What qualifies as a hardship withdrawal from a retirement plan?
A hardship withdrawal is defined as a distribution made due to an “immediate and heavy financial need.” It is limited to the amount required for that need. The amount withdrawn is taxable as income but is not subject to an IRS penalty. The ability to re-pay the hardship withdrawal depends on the terms of the specific retirement plan.
To qualify as a hardship withdrawal, the distribution may be used in any of the following situations:
Note that similar rules apply to other tax-qualified plans permitting elective deferrals, such as a 403(b) plan offered to employees of a tax-exempt organization.
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