How does a QDRO avoid taxation?

Pennsylvania residents should understand how a QDRO can help them prevent high taxation when splitting a retirement account during a divorce.

Couples in Pennsylvania know that loss of some assets can be a part of any divorce. However, there are some losses that do not need to occur if the right steps are taken up front. These involve the need to pay high taxes and even other fees if a 401(k) or other similar company-sponsored retirement account must be split as part of an asset division settlement.

The utilization of a Qualified Domestic Relations Order can help spouses avoid losing significant portions of their retirement savings unnecessarily. Learning what a QDRO is and how it works is vital for anyone facing a divorce in which a retirement account may be split.

Life without a QDRO

Forbes gave an example of a former husband who took money from his retirement account to pay his ex-wife. This was done at the direction of a family court judge and was pursuant to the couple's divorce settlement. No Qualified Domestic Relations Order was filed in this case. The amount withdrawn was roughly $50,000.

The man received an unexpected tax bill amounting to 10 percent of the funds he took out of his 401(k) account. The taxes were assessed because the lack of a QDRO allowed tax entities to view the transaction as a non-qualified distribution. In essence, the lack of proper procedure cost the man approximately $5,000 quite unnecessarily.

How can a QDRO help?

As explained by the U.S. Department of Labor, retirement funds are set up under one person's name only, even for married persons. Distributions are only legally allowed to be made to that person and only when that person meets all retirement criteria. Any other distributions are subject to specific taxes.

When a Qualified Domestic Relations Order is filed, it establishes another party as an authorized payee on the account. This person can legally receive funds as outlined in the QDRO for qualifying domestic instances such as child support, spousal support or asset division settlements.

A QDRO can outline in detailed fashion how much money should be paid, how frequently and on what date or dates. Payments can be made in installments or be one-time occurrences. Any payments related to alimony or child support orders will be made with no tax repercussions to any party.

The Internal Revenue Service explains that payments related to a property division settlement can result in the receiving spouse being assessed taxes. This can happen if that person does not adequately reinvest the funds. The QDRO may not be able to protect the receiving spouse from taxation in this case but it can protect the account holder from being liable for the taxes.

How can spouses get proper guidance?

Working with an experienced family law attorney from the outset of a divorce is always recommended. This gives Pennsylvania spouses the best chance of understanding how to preserve valuable assets.