A. ERISA Qualified Plans. Normally, there is no tax consequence associated with the transfer of an Employee Retirement Income Security Act (ERISA) governed retirement account between spouses incident to a divorce, provided the transfer is effectuated through the proper instrument and the account is not being liquidated. A Qualified Domestic Relations Order (QDRO) is a domestic relations order that provides for the payment of a participant’s benefits under an ERISA employee benefit plan to an “Alternate Payee” provided it meets the provisions of IRC Section 414(p) and ERISA Section 206(d)(3).
B. Common Types of Retirement Plans. The common types of retirement accounts seen in divorce cases include IRAs, 401(k) plans, 403(b) plans, 457 plans and other defined contribution and defined benefit plans. However, not all tax deferred retirement accounts require a QDRO to transfer between spouses. For example, a divorce instrument meeting the definition established by IRC 71(b)(2) allows an IRA to be transferred between spouses without a QDRO. A divorce or separation decree is all that is needed to transfer certain types of IRAs between a spouse or former spouse.
Further, IRC Section 408(d)(6) provides that an IRA transferred from a spouse to a spouse or former spouse incident to a divorce or separation instrument is a non-taxable transfer.
However, most ERISA qualified plan do require a QDRO to transfer between spouses incident to divorce or separation. Entry of a QDRO is an exception to the general rule that prohibits alienation or assignment of a spouse’s interest in benefits accumulated under a retirement plan subject to ERISA.
C. Early Withdrawal Penalty. Normally, there is a 20% withholding of a lump sum cash out made to a spouse or former spouse from a defined contribution plan subject to ERISA. Although IRC Section 72(t) provides that there is also a 10% penalty associated with the liquidation of a qualified retirement plan as defined in Section 4974(c), Section 72(t)(2)(C) specifically provides that distributions pursuant to a QDRO are not subject to the penalty that generally applies to retirement benefits distributed prior to the recipient reaching the age of 59½.
Unlike the exception to the early withdrawal penalty for the liquidation of a qualified retirement plan pursuant QDRO, there is no exception to the early withdrawal penalty enumerated in IRC Section 72(t)(3)(A) for the early distribution of an IRA. Therefore, a spouse or former spouse who has an option to liquidate an ERISA qualified plan versus a non ERISA qualified IRA (Traditional, Roth and Educational) should choose the ERISA qualified plan to avoid the additional 10% early withdrawal penalty.