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Donald DeGrazia
QDROs in divorce

A qualified domestic relations order (QDRO) is an underused option in the search for collateral and security in marital settlement agreements.

April 11, 2013
by Donald J. DeGrazia, CPA/ABV/CFF

How often have you seemingly reached a settlement in high-asset, low-liquidity divorce cases only to be stymied by lack of collateral or security for deferred payments? How does the recipient spouse secure alimony and/or deferred equitable distribution from default risk?

Death and disability are easy (on the recipient at least): Those risks can be covered by insurance. The traditional methods, collateral position in closely held stock or a second (or third) mortgage on a residence are problematic: How liquid or marketable is closely held stock? In this economy, how much equity exists in already mortgaged properties? And suppose there is a bankruptcy?

Practitioners should consider the most underused source of collateral: a qualified domestic relations order (QDRO). A QDRO is defined as “a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent” (see IRS website, “Retirement Topics, QDRO, Qualified Domestic Relations Order”). A QDRO must meet the requirements of Sec. 414(p).

QDROs provide the perfect collateral because they are exempt from the Sec. 401(a)(13)(A) anti-alienation and anti-assignment provisions  and the equivalent ERISA provisions under 29 U.S.C. §206(d)(1), and immune from the grasp of creditors.

How does a QDRO become collateral?

Typically, the following steps are used:

  • The payer spouse’s retirement plan is made subject to a QDRO as part of the divorce agreement;
  • A percentage of the amount in the retirement plan is assigned to the recipient spouse as part of equitable distribution;
  • The remainder is apportioned to the payer spouse and remains in the plan; and
  • The judgment of divorce assigns a security interest in the payer spouse’s remaining share of the plan to the recipient spouse to secure the payer spouse’s obligation to the recipient spouse.

The IRS has issued two favorable letter rulings addressing the use of QDROs as security: Letter Rulings 9234014 and 200252093.

The QDRO can secure the payer spouse’s obligations under the divorce agreement, including:

  • Deferred equitable distribution payments;
  • Alimony and child support; and
  • Education obligations.

Generally, the alternative payee (recipient spouse) is taxed on the distribution (although the 10% penalty for early withdrawal does not apply (Sec. 72(t)(2)(C))), but after-tax dollars are better than no dollars. In addition, because the spouse is treated as if he or she were a plan participant, the payer spouse’s cost basis is allocated in part to the recipient. The payer spouse is not taxed on the distribution, unless the distribution is paid to a child or other dependent, not the spouse or former spouse (IRS Publication 575, Pension and Annuity Income, page 4), in which case the payment is treated as if it is child support.

To minimize the effect of taxes on the recipient spouse, consider seeking a “grossed-up” distribution if funds are sufficient to cover the taxes, too. It is also possible to roll over the money into an IRA (if the recipient is the spouse or former spouse), which can defer taxation. The spouse must roll over the money within 60 days of its receipt.

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Donald J. DeGrazia, CPA/ABV/CFF, is a partner with Gold Gerstein Group LLC in Moorestown, N.J. He will be speaking on "Goodwill and Double Dipping Issues for Divorce," on May 9 at the AICPA Family Law Conference in Las Vegas.