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Divorce and Retirement Plan Proceeds: A Case Study

It is rarely pleasant to discuss divorce, yet it is an unfortunate occurrence that happens with increasing frequency in our society. Because divorce involves the dividing of assets, some of which have tax implications, it is important to be aware of the “tax traps” that may be lurking. One such trap exists in the area of retirement plan assets because of the existence of vested account balances.

In the past, with traditional defined benefit plans, the plan participant was promised a retirement benefit, but had no vested retirement account balance. However, with the recent shift toward defined contribution plans, vesting for employee contributions is immediate, and vesting for employer contributions builds quickly. Consequently, as more Americans participate in 401(k) plans and other defined contribution retirement plans, dividing vested retirement plan assets in divorce situations has created complex financial issues.

A True Case History

In 1987, a New Mexico orthodontist (Dr. Arthur Hawkins) agreed to give his wife (Glenda) $1,000,000 from his retirement plan as part of their divorce agreement. He assumed Glenda would be responsible for paying taxes on the money since she would eventually have control of it. After all, he wasn’t taking money out of the plan. . .or so he thought. Neither he nor Mrs. Hawkins reported the distribution on their separate 1987 tax returns.

In 1989, the Internal Revenue Service (IRS) demanded that both parties include the distribution on their separate 1987 tax returns, prompting each to petition the Tax Court for a ruling. In A. Hawkins, 102 TC 61, Dec. 49,638, the Tax Court ruled that the divorce agreement was not a qualified domestic relations order (QDRO), leaving Dr. Hawkins with a federal income tax bill of almost $400,000, while his ex-wife received the $1,000,000 tax free. Fairness would seem to dictate that the spouse receiving the money would pay the tax on it, and that may have been the case had the taxpayer filed a QDRO as part of the divorce decree.

A QDRO is a judgment or order that relates to child support, alimony, or property rights pertaining to a spouse, former spouse, child, or other dependent. A QDRO can be used to establish one spouse’s right to part or all of the other spouse’s retirement plan(s)—and ensures the recipient spouse pays the tax.

To be protected through a QDRO, it must specify:

The name and address of the plan participant and the “alternate payee” (typically, the participant’s spouse).
The name and account number of each retirement account involved.
The percentage (or dollar amount) of each plan that is to be paid to the alternate payee.
The period of time, or the number of payments, covered by the QDRO.

The QDRO must go in the divorce decree or court-approved property settlement document. The decree should also specify that a QDRO is being established under Section 414(p) of the Internal Revenue Code (IRC) and the particular state’s domestic relations laws. Intent to establish a QDRO is insufficient; it must be spelled out in the divorce papers.

In Hawkins, it was the position of the Tax Court that the divorce agreement was not clear enough to recognize or assign rights in the benefits payable under the plan to the former wife as an alternate payee, one of the statutory requirements for a QDRO.

On Second Thought...

Dr. Hawkins appealed the Tax Court decision and received a favorable ruling in 1996 (Hawkins v. Comm., 86F.3d982, 10th Cir. 1996) in which the 10th Circuit Court maintained that the Tax Court’s reading of the Section 414(p) requirements was too narrow. Specifically, the Appeals Court held that the exact wording of Section 414(p) did not have to be present in the decree in order for the QDRO requirements to be met.

Getting divorced can be “taxing” enough, but it need not be made more difficult by mishandling the division of assets in a retirement plan. And, although this particular decision does appear to provide room for straying from the precise wording of the statute, applying the proper language in a divorce decree may ease some of the inevitable complications that can arise and aid in a smoother transition for all involved. At a minimum, qualified legal advice should be obtained to ensure that any desired planning actions are properly worded and structured.

This information is being provided for informational purposes only and is not intended to be interpreted as specific legal or tax advice. Neither MassMutual nor any of its employees or representatives are authorized to give legal or tax advice. Individuals are advised to seek the guidance of their own personal legal or tax counsel.

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