Suppose you and your divorcing spouse have reached your final settlement agreement. You’ve made arrangements to allocate parenting time and responsibility. You’ve determined the correct amount in child support. Alimony has been decided. You’ve divided your marital property and debts, including your retirement accounts. You’re ready to convert your agreement into a divorce decree, right?
You need to take one more step. IRAs, 401(k)s, 403(b)s and other retirement accounts often have tax advantages. When they do, the saver is prevented from withdrawing the money before they reach retirement age; early withdrawals result in penalties and sudden tax bills.
These accounts are held by trustees, and those trustees are responsible for ensuring that any premature withdrawal results in payment of the previously unpaid taxes and an early withdrawal penalty. But you would like to divide your retirement accounts now.
It may seem that all that is needed is your divorce decree, which will set out how the retirement accounts should be divided. In reality, you need more.
You may need a QDRO, or qualified domestic relations order. This is a court order giving the account administrator the authorization to actually divide the accounts as specified. If you or your divorcing spouse is part of a public retirement system governed by the Illinois Pension Code, you will need a QILDRO, or qualified Illinois domestic relations order. Under Illinois law, public retirement systems cannot honor QDROs.There are other differences between QDROs and QILDROs that you should discuss with your divorce attorney.
A QDRO or QILDRO is the only way to avoid a taxable event
Suppose your divorce settlement says that your divorcing spouse will get 50% of your retirement account. If you took the money out of the account and gave it to your ex, that would be a taxable event. When a taxable event occurs, all the tax that has previously been deferred on the amount being withdrawn comes due. You would owe those taxes even though you didn’t keep the money for yourself.
On top of the tax bill, you might also be liable to an early withdrawal penalty. This would occur if you were younger than 59-1/2 years when you took out the money.
Instead of taking the money out of the account and handing it over, you want to have the account’s administrator transfer the money to an account of the same type that is owned by your ex. When money is transferred by the trustee between one tax-deferred account and another, you avoid the taxable event and the early withdrawal penalty.
To avoid trouble, submit your QDRO or QILDRO before your divorce is finalized
A QDRO or QILDRO is only effective if it complies with the plan’s rules. Some plans, for example, will not transfer the money to another account at all. Instead, the administrator will disburse the money to your ex upon their retirement.
Your divorce lawyer will prepare a QDRO or QILDRO for the judge to convert into a court order. Ideally, you would submit this court order to your retirement plan or plans right away so that you can be sure it complies with the plan rules. That way, if a problem arises, it’s relatively easy to go back to court and have a modified order issued. If you don’t discover the problem until years have gone by, you might have to reopen your divorce or go without retirement assets that you were counting on.