ERISA, Qualified Plans and Divorce

“ERISA, Qualified Plans and Divorce,” this is the topic of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Ed Beckwith, ACTEC Fellow from Washington, DC. The rules that govern the division of retirement assets can be very complicated. To do so in the context of divorce, even more so. To learn more about this challenging topic, we will be hearing today from ACTEC Fellows Bob Kirkland of Liberty, Missouri and Justin Miller of San Francisco. Welcome, Justin and welcome Bob.

Tax Issues with ERISA, Qualified Plans in IRAs in Divorce

Thank you very much. This is Justin Miller. Today, I’m going to cover some of the tax issues involved with qualified plans in IRAs in divorce. And then I’m going to turn it over to Bob Kirkland to cover some of the planning issues that we might have to deal with, with these types of retirement plans in IRAs and divorce. So, with that, let’s just jump right into qualified plans.

Now, these are plans that are subject to ERISA, the Employee Retirement Income Security Act of 1974. Now, those of you that think the Internal Revenue Code is complicated and that puts you to sleep at night, you have not had the pleasure of reading ERISA. Completely different set of rules. And when it comes to qualified plans and divorce, you have to follow those rules. Otherwise, you can run into some enormous trouble. So, to divide a retirement — a qualified retirement–plan under ERISA in a divorce, you have to get what’s called a Qualified Domestic Relations Order or a QDRO. Or, if you want to be cool around the family law community, the acronym, you would pronounce it QDRO, Q-D-R-O or QDRO. You have to do it correctly. Otherwise, it’s not just a problem for the spouse who is getting a divorce; you could actually disqualify the entire plan. It could cause immediate taxation for everybody in the plan. Jeopardize the tax-exempt status. So, you’ve got to do the QDRO correctly.

Now, for major corporations that are used to employees getting a divorce, they are very familiar with QDROs. Where you really might run into an issue is with smaller, closely held companies and you’ve just got to make sure you bring in the right experts and specialists to make sure that QDRO is done correctly. And if you do that, then what happens is you more or less can just divide that QDRO plan from one spouse and you can make the alternate payee, the other spouse, a beneficiary of that plan. Couple things to remember after you do this QDRO plan or you divide the plan — that alternate payee, that former spouse, can take the money out. But luckily, it will still be subject to ordinary income tax when that money comes out because it’s never been taxed before. They just become a new beneficiary of that plan. But the really nice thing, though, is you can take money out of that QDRO plan before the age of 59 1/2. And while there will be ordinary income tax, there will not be a 10 percent penalty. So, that’s the nice part. If you’re under the age of 59 1/2, you can take that money out without a 10 percent penalty.

So, what do most people do when you QDRO’d the plan or divided the plan with the QDRO? Well, you really have two main options. Most of our clients tend to roll over that former spouse’s plan into an IRA. There are several reasons for doing that. A lot of our clients, they don’t want to be a participant in their former spouse’s plan. They don’t want anything to do with their former spouse, let alone, their former spouse’s employer. IRAs can often offer greater control over investments, sometimes lower fees, and more flexibility with beneficiary designations.

So, does that mean you should always roll over the plan to an IRA? And the answer is no. There are two really important reasons not to roll over those funds into an IRA, the QDRO plan. By keeping it in the plan — one, you tend to get better creditor protection. ERISA does tend to provide better creditor protection than IRAs. The second reason is that you can take that money out before 59 1/2 without a 10 percent penalty. Once you roll it over into an IRA, if you take that money out before 59 1/2, you will get hit with that 10 percent penalty. Now, there’s a special exception for IRAs for Substantially Equal Periodic Payments or SEPP status. But in general, if you think you’re going to want or need that money before 59 1/2, don’t roll it over into your IRA. Here’s the nice part, though. There is no rush for you to decide, if and when you want to roll it over to your IRA.

So, if you’ve got a QDRO plan — we recently had a situation where a woman had this QDRO plan; there was a million dollars in it from her former spouse. And we ran all the numbers in the world, Monte Carlo simulations to show that she could roll over the entire million and she wouldn’t need to touch that money until she was 59 1/2. However, she would feel more comfortable knowing that at least half of those funds would be there if she ever just felt like getting to the money before 59 1/2. So, what’s the solution? Well, what we did at 55 during the divorce, after the divorce, we rolled over half of the QDRO plan to an IRA — $500,000 — and we kept the other $500,000 in her former spouse’s plan. And we kept that going with the idea that once she turned 59 1/2, we could roll over the other half of the assets into the IRA down the road. So, there’s no rush to do it and it’s not an all or nothing. You can roll over some in the beginning and you can wait and see and roll over some later. But those are ERISA plan, qualified plan.

What about IRAs? IRAs are governed by the Internal Revenue Code, not ERISA, Section 408. You do not do a QDRO. But how do you divide an IRA in a divorce? The only times you can really divide or give someone an IRA tax free is really if you die. Or the second time would be in a divorce. And to do it in a divorce, there are two very, very important rules. Number one, to divide the IRA it has to be pursuant to a divorce decree or a “written instrument incident to such a decree.” Now, I’ve read the entire Revenue Code cover to cover. Fantastic reading. And I can tell you, nowhere in the Internal Revenue Code does it define written instrument incident to such a decree. What does that mean? It means you better make sure your divorce decree mentions that written instrument, refers to it, attaches it, something like that because we want to make sure we stick with the rules. That’s requirement number one.

Number two is it has to be a trustee-to-trustee transfer. One spouse can’t take the money out, put it in their bank account and then write a check to the other spouse. It’s got to go directly from the one trustee to the other IRA trustee. All of that being said, if you follow those rules, then you are able to divide that IRA correctly.

One more little tip, though, is you probably want to make sure that that divorce is finalized before you actually transfer those funds. Even with the trusteeto-trustee transfer, there is always a possibility that, that spouse could die before the divorce is finalized, in which case they’ve taken the money out too early. They took it out before they were dead. They took it out before they were divorced. There’s also a possibility spouses can reconcile. They may be going through this divorce process and if they’ve taken money out of their IRA and transferred it to the other spouse’s IRA and they don’t get divorced, that’s a big no-no. That’s a big taxable event. But once you divide the IRA correctly, once you follow those rules, it basically becomes the other spouse’s IRA. They can name their own beneficiaries. Regular income tax treatment. And so, that generally falls under the usual IRA tax rules. But those are just the tax issues we need to look at in the divorce with retirement plans, with IRAs, but there are a lot of planning issues, beneficiary designation issues. And with that, let me turn it over to Bob Kirkland.

Planning Considerations with ERISA, Qualified Plans and Divorce

Thank you so much, Justin. Probably one of the most common estate planning screw ups we’ve all seen over the years is when we inherit an estate, a decedent’s estate, where that decedent was divorced and never got around to changing their beneficiary designations on their retirement plans and IRAs. The general rule under ERISA, which as Justin correctly described, is very unforgiving. It basically says the beneficiary designation on file with the employer that is done pursuant to the employer plan will control who receives the funds.

Now, I’m from the State of Missouri. We have a very elaborate nonprobate transfer statute. And arguably, the blanket definition of nonprobate transfer covers a beneficiary designation under an employer-provided retirement plan. That statute includes a very important provision that on its face looks like it might save you; because it says after an owner makes a beneficiary designation, if that owner’s marriage is dissolved or annulled, any provision of the beneficiary designation in favor of the owner’s former spouse or a relative of the owner’s former spouse is revoked on the date the marriage is dissolved or annulled — whether or not the beneficiary designation refers to marital status. Unfortunately, that provision, which is helpful in many cases, does no good for you in conjunction with an employer-provided plan. That plan is subject to ERISA and there are numerous cases over the years which have held that ERISA preempts any and all state laws that might appear to override any provision of ERISA.

Now, where a statute, like the one I described, could save the day is in connection with an IRA. Because as Justin pointed out, IRAs are not subject to ERISA, a common misconception on many planners’ part. So there, that’s my statute and the statutes of your state, if they exist, that could save the day and allow that spouse, that former spouse, to be deemed to have predeceased the owner of the IRA. Bottom line is, don’t rely on a statute to save you. Make sure we counsel our clients post-divorce to get not only their whole estate plan updated, but especially these beneficiary designations.

On a related note, somewhat related, there have been a series or a flurry of recent cases involving issues where a prenuptial agreement has previously been executed by the spouses and as part of that agreement, as my form normally includes, is a mutual waiver of interest in the fiancé’s future spouse’s retirement plans or IRAs. And in conjunction with that waiver, there is an agreement to execute a consent to the new spouse’s beneficiary form because at the moment of the execution of the agreement, usually those forms are not appropriate to be signed yet. And again, what happens is marriage happens, bliss happens, beneficiaries don’t get updated and there is a problem.

Well, we have good news here for the most part in that even though ERISA would say that the beneficiary designation still covers or the provisions of the plan in default of a designation, we have some case law that basically says if a spouse violated a prenuptial agreement by wrongfully retaining the proceeds of the deceased spouse’s 401(k) or pension plan proceeds, there is a right of action. And despite the ERISA preemption, that the children of the deceased spouse can sue the surviving spouse on a breach of contract claim, provided the agreement was drafted correctly. So, those provisions in the prenup must not only say that each spouse waives, but each agrees to consummate that waiver through lawfully executing a consent. If they fail to do that consent, ERISA controls the distributions of the proceeds. But there is definitely a right of action, a contractual right of action for breach of contract because that spouse did not abide by the prenup and properly execute a consent.

So, that’s our highlights of beneficiary designations and income tax consequences related to divorce and retirement plan beneficiaries. And we thank you all very much for your attention.

Justin and Bob, thank you for reminding us of the key issues we all need to consider when a divorcing client is dividing assets that are controlled by the ERISA and qualified plan rules.

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