Tax Issues Relating to Qualified Domestic Relations Orders and Divorce

An increasingly large portion of the assets of married couples consist of rights to payments and stock from pension plans.  In many states such assets are subject to division during a divorce.  Divorce and division of property are generally controlled by state law, but pension plans are controlled by federal law in many respects.

 
Pension Plans and ERISA
A major advantage of saving for retirement through a pension plan is that contributions from employees and employers for plans such as a 401(k) plan are not taxed as income until distributed by the plan, usually after retirement, at lower tax rates. However, under provisions of the Federal Internal Revenue Code, the assignment of pension benefits, including transfers to a spouse during divorce, may result in the loss of such tax benefits.
 
In 1984, Congress passed the Employee Retirement Income Security Act (ERISA), which governs most private pension plans (government and some other plans are not covered, nor are IRAs).  To remedy the anti-assignment problem, the Retirement Equity Act of 1984 (REA) amended ERISA to establish an exception to the anti-assignment bar to division of ERISA plan benefits during divorce. 
 
Federal Tax Treatment of QDRO Plan Distributions
To avoid adverse tax consequences, the plan participant/spouse must obtain a "Qualified Domestic Relations Order" (QDRO).  A QDRO is usually entered by the court, although under certain circumstances other entities may approve a QDRO.  The QDRO must also be approved by the administrator of each plan affected. 
 
The QDRO must contain certain information specified in ERISA, as amended by REA, including the names and addresses of the plan participant and the recipient(s) of the court award (the "alternate payee").  There are also certain provisions that are prohibited in a QDRO, including the authorization of plan benefits and payouts that are not allowed by the plan.
 
A QDRO creates or recognizes an "alternate payee's" right to receive all or a portion of the plan benefits, or it may actually assign that right to the "alternate payee."  An "alternate payee" may only be a spouse, former spouse, child, or other dependent of the plan participant.  A validly created and approved QDRO allows the recipient spouse to be treated, for federal income tax purposes, as a plan participant.  In addition, the QDRO may allow the alternate payee to take a lump sum withdrawal (if allowed by the plan) or commence payments at the earliest time allowed for retirement, regardless of when the participant actually retires.
 
Consequences of Plan Withdrawals Absent a QDRO
If a court orders the division of an interest in an ERISA pension plan during a divorce and the plan participant simply pays the amount from the pension plan without obtaining a QDRO, the participant may become liable for an early withdrawal penalty of 10% (depending on age and method of withdrawal), plus income and/or capital gains taxes on the amounts distributed to the former spouse.  Federal courts have repeatedly upheld this principle, despite claims of plan participants that they were forced to comply with the court's order and had no other source for the payments, and therefore should not be penalized.
 

Absent a QDRO, the amount withdrawn from the plan thus becomes income and/or capital gains to the plan participant, not the former spouse.  If a valid QDRO is in place, however, the distributions from the plan are treated as income and/or capital gains to the alternate payee/spouse.  However, if distributions from the plan are used to satisfy child support or payments to some other dependent of the plan participant/spouse, the distributions are still treated as taxable to the plan participant/spouse for federal income tax purposes, notwithstanding the existence of the QDRO.

Successful Divorce Mediation

Divorce mediation, an alternative to traditional divorce proceedings, is a means to resolve the complex issues of a divorce. Mediation involves the services of a trained and neutral person who works with the parties to facilitate the settlement of disputed issues. Such person is known as the "mediator."

In traditional divorce proceedings, the judge ultimately determines child support, child custody, spousal support and property issues. Mediation, on the other hand, allows couples to control the outcome of their divorce. Additionally, the mediation process is non-adversarial in nature, which is especially important for couples with children, as like-minded parents can establish parenting plans with minimum disruption to the lives of their children.

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Marital Settlement Agreements and Life Insurance Policies

Many marital settlement agreements require one party to maintain a life insurance policy on his or her life naming the former spouse as the primary beneficiary. While this provides some financial security for the former spouse, it may also result in an adverse unintended tax consequence for the insured spouse's estate.

For example, if the ex-husband is required to maintain a $1 million life insurance policy on his life, naming his ex-wife as beneficiary, on the ex-husband's death his ex-wife will receive the $1 million face amount of the policy directly from the life insurance company. If the ex-husband was the owner of the life insurance policy and paid the premiums on the policy, the IRS will include the $1 million face amount of the policy in the ex-husband's estate for the purposes of calculating the amount of estate tax owed by the ex-husband's estate. If the ex-husband died in 2007 with a taxable estate of $3 million plus the $1 million in life insurance, the inclusion of the life insurance proceeds would result in a $450,000 increase in the estate tax owed.

The foregoing result may be avoided through the use of a tax-sensitive marital settlement agreement and an irrevocable life insurance trust. The ex-husband may still be required to maintain a $1 million life insurance policy with his ex-wife as beneficiary, but the life insurance policy would be owned by the trustee of the irrevocable life insurance trust. The ex-husband may transfer money to the trust for the payment of the premiums. Since the payments are required pursuant to a court order, the payments are not considered taxable gifts. Since the irrevocable life insurance trust, not the ex-husband, is the owner of the policy, the $1 million life insurance policy will not be included in the ex-husband's estate for the purpose of calculating the estate tax owed.

Qualified Domestic Relations Orders and Divorce Settlements

It has been estimated that more than one half of all first marriages end in divorce; the number of failed marriages is even higher for second marriages. One major issue in most divorces is the division of property. Commonly, a large portion of the marital assets consist of rights in or payments from one or more pension plans.

Pension Plans and ERISA
Divorce and division of property are generally controlled by state law. However, when state law contradicts or is inconsistent with federal law, the federal law "preempts" the state law; federal law controls the outcome. In 1984, Congress passed the Employee Retirement Income Security Act (ERISA), which governs most private pension plans (government and some other plans are not covered).

Federal law prohibits the assignment of pension benefits in ERISA plans. This appeared to include transfers to a spouse during divorce, regardless of a state court decision on division. To remedy this, the Retirement Equity Act of 1984 (REA) established an exception to the rule through use of a "QDRO."
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Deductibility of Divorce-Related Payments

Prior to filing for divorce, various federal tax considerations should be reviewed due to their potentially profound implications. Among the major issues commonly covered in a divorce decree or agreement are: alimony, sometimes referred to as "spousal" or "separate maintenance" support; division of property; and child support. Each has its own tax treatment and implications.
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Alternative Ways to Handle a Divorce

Today, couples seeking a divorce have options to consider outside of traditional legal proceedings. Parties to a divorce are becoming increasingly aware of the expense, time and emotional toil of adversarial litigation, and are looking to options that better suit their financial and emotional needs. The following three options are alternatives to traditional divorce proceedings that mesh alternative dispute resolution with traditional lawyering skills to settle a divorce.


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About Divorce in Illinois

Your Illinois Divorce

WHAT TO EXPECT ABOUT YOUR ILLINOIS DIVORCE

What are the Legal Issues Involved in Ending a Marriage

In the U.S., a divorce* is the means by which the marriage between a couple is legally terminated. A judgment for divorce means that the parties have reached an agreement or, if the parties cannot agree, a judge has made a decision regarding the children of the marriage (custody, support, and visitation) and the couple's financial affairs. Following a divorce, each party is free to remarry and is also able to resume a former (maiden) name.

Other issues to consider before the divorce is final are the needs for medical insurance or life insurance; obligations on a mortgage if one party stays in the marital home; and tax implications of property division or financial awards.

*The law in Illinois now uses the word "dissolution" rather than "divorce." In order to be clear and consistent, this pamphlet will refer to the process as "divorce."

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Alternatives to Traditional Divorce Proceedings

Today couples are looking for alternatives to litigation, in the administration of their marital dissolution. In traditional divorce matters, a judge will ultimately decide the divisions of property, spousal support, child custody and child support.

Many couples now seek to be more involved in the resolution of the divorce issues. One alternative dispute resolution method by which spouses can gain more control over the process and outcome of their divorce is through an advisory opinion.

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Alan Pearlman, Ltd. : 707 Skokie Boulevard, Suite 600, Northbrook IL, 60062

Tel: 847-205-4383 Email: theelectroniclawyer@comcast.net

Chicago Divorce Lawyer & Attorney : Pearlman Law Firm : Family Law: Divorce, Child Support, Visitation, Child Custody, Property Division, Alimony, Legal Separation, Modification, Paternity, Marriage, Prenuptial Agreement, and Property Division.