Spring 2024: ACFLS Family Law Specialist, “The problem with QDROS and 401(K)s — They are not as easy as they seem

By Pete Neuwirth FSA FCA and Barry Sacks JD Ph.D, founders, Neuwirth Associates Consulting

As the prevalence of “Silver Divorce” (divorce where at least one spouse is age 55 or older) continues to increase dramatically, the need for family lawyers to consider the complexities of dividing up Qualified Retirement Benefits has become more challenging.

While utilizing a “QDRO” (Qualified Domestic Relations Order) seems to be a straightforward approach, particularly in cases where 401(k) Plan(s) comprise the bulk of a divorcing couple’s retirement assets, in practice, QDROs pose extremely difficult issues for all of the professionals involved in reaching and implementing final divorce settlements. Those experts might include CPAs, CDFAs, CFPs, tax advisors, and others who provide analysis to both the courts and to mediators seeking a negotiated settlement. This article describes some of those issues and suggests approaches that family lawyers and their clients consider to avoid having to utilize a QDRO to divide Qualified Retirement Plan benefits.

What is a QDRO and why do Plan Sponsors and Plan Administrators hate them?

One of the key, inviolable, and fundamental principles of ERISA that has been incorporated into the Internal Revenue Code is that assets in a Qualified Plan Trust can only be used for the “exclusive benefit” of Plan participants and their beneficiaries. The Exclusive Benefit Rule is explicitly described in both the Employee Retirement Income Security Act of 1974 (“ERISA”) section 404 (a)(1)(A) and the Internal Revenue Code (“IRC”) section 401(a)(2)2

It is important to note that for purposes of this rule, “beneficiary” is explicitly defined and includes only the person or entity designated by the participant or the Plan who is entitled to survivor benefits after the participant dies3. Thus, in the absence of a QDRO, as long as the participant is alive, no distributions can legally made from the Plan to anyone other than the participant, even if the participant’s spouse happens to be the named beneficiary within the meaning of Treasury Regulation 1.401-(1)(b)(4).

It is also important to understand that IRC section 401(a)(2) covers BOTH defined benefit and defined contribution plans.

For Defined Benefit Plans, the Exclusive Benefit Rule means that all assets are available for all Plan benefits but also requires that as long as the participant is alive, those assets can only be used to pay benefits to him/her. For Defined Contribution Plans (e.g. a 401(k) Plan) the account balance (i.e. amounts contributed and interest earned) can only be distrib- uted to a Plan participant, or after the participant dies, any remaining account balance can only be paid to the named beneficiary.

Because under state law Qualified retirement benefits are generally considered a marital asset subject to division upon divorce, ERISA created the concept of a Qualified Domestic Relations Order which is defined in IRC section 414(p).

QDROs are a narrowly defined and limited exception to the Exclusive Benefit Rule. Specifically, QDROs provide a mechanism for reconciling State and Federal law that allows Plans, in the case of a divorce, to distribute assets to an “alternate payee” (i.e. the non-participant spouse) who can receive distributions from Plan assets while the participant is alive. Administrative expenses (including the cost of implementing the QDRO) can be paid out of plan assets as a “settlor expense” but benefit payments to a non-participant spouse, absent a QDRO that complies with IRC requirements are strictly forbidden.

Furthermore, the consequences of violating the Exclusive Benefit Rule are severe, including disqualification of the entire Plan—something both plan sponsors and plan administrators, who have fiduciary responsibility to both sponsor and participants, will seek to avoid at all costs4.

QDROs for Defined Benefit Plans (including Hybrid Plans)

In the case of a defined benefit plan, except for certain “settlor expenses”5 the Exclusive Benefit Rule requires that all assets be available to pay benefits for all Plan participants. In particular, IRC section 414(p), in addition to defining what a QDRO is, describes the follow- ing two fundamental principles that all QDROs must adhere to in order not to jeopardize the tax qualified status of the Plan.

1. No QDRO can ever increase the actuarial liabilities of the Plan6. 2. No QDRO can ever provide an optional form of benefit to the alternate payee that was not avail- able to the Plan participant imme- diately before the QDRO is to be effective.

These two requirements are often quite difficult and problematic from a practical standpoint in the case of Silver Divorce.

Consider, for example, a situation where the Plan participant’s male spouse (“husband”) is 60 years old and has an accrued benefit under his company’s defined benefit pension plan of $800/month, payable as a life annuity beginning when he turns 65. Assume that the Plan does not currently provide any optional lump sum form of payment and that his nonparticipant spouse (“wife”) is 55.

Assume that the couple had been married for the entire period the benefit accrued. Under IRC section 414(p)(3)(A), a QDRO cannot provide the wife a $400/month benefit payable to her over her lifetime because her longer life expectancy would increase the actuarial liabilities of the Plan. Therefore, in this case, the QDRO can only provide benefits to the alternate payee over the participant’s life commencing as early as the participant’s “earliest retirement age”. To the extent payments are made earlier than when the husband reaches Normal Retirement Age (in this case, age 65), the benefit must be actuarially reduced further.

In addition, under the restrictions of IRC section 414(p)(3)(B), the Plan cannot even pay the lump sum actuarial equivalent to the wife because the husband could not have received a lump sum payment of his benefit had the divorce not occurred.

As can be seen above, IRC section 414(p)(3) poses chal- lenges even in a case where the entire pension benefit is community property to be divided equally between the two divorcing spouses.

In practice, it is quite likely that the period over which a participant accrues a pension benefit will not be exactly coincident with the tenure of the marriage. In those cases, the challenges associated with accurately determining how much of the participant’s accrued benefit is separate property and how much is community property subject to division
by QDRO can be almost impossible. Some of the factors that will make such a determination an extremely difficult actuarial task include the following:

  1. Even for a participant who never changed employers, it is likely that the Plan has undergone multiple changes
    in Plan provisions (e.g. benefit formula, early retirement provisions, optional forms of benefits, service definitions etc.). The effect of each of those plan changes needs to be allocated to pre- and post-marital services.
  2. Many participants have complicated employment histories (e.g., breaks in service, transfers to other divisions or positions with different benefit formulas, etc.)
  3. Many plan sponsors have been acquired or merged, creating multiple plan formulas that run simultaneously, requiring careful application of the “same desk” rule9.
  4. Some participants have breaks in service or have received prior distributions from the Plan, which need to be accounted for upon reemployment if the Plan provides for the reinstatement of past service.
  5. To the extent a Plan spinoff or merger has occurred during the participant’s career, key records on a participant’s service or compensation history may no longer be available.

In addition to data lost due to a Plan merger or spinoff, much of the information required by an actuary to determine the value of the portion of the participant’s benefit that should be considered community property is simply not available. While Qualified Plan administrators are required to maintain historical Plan provisions to enable such calcula- tions, historical data on a participant’s pay and employment history is not always maintained back to an employee’s date of hire. This is particularly the case when the Plan sponsor has changed (via merger or acquisition) or the participant has had a particularly long break in service.

Finally, it is important to note that many Qualified Plans are Hybrid Plans (e.g. Cash Balance) and while a Hybrid Plan is often communicated to participants as if it were defined contribution/account-based Plan, in fact such Plans are technically Defined Benefit Plans subject to exactly the same restrictions under IRC section 414(p) as any other Defined Benefit Plan.

Specific Problems with 401(k) Plans

As described in endnote 5, the Department of Labor regulates which expenses are “settlor expenses” and when Plan assets can be used for purposes other than to pay Plan benefits. Slightly different rules govern 401(k) Plans due to the individual account-based nature of such Plans, but the restrictions are just as strict. For example, forfeitures from non-vested terminations in a Profit Sharing Plan can only be reallocated to other participant accounts or to reduce employer contributions10.

Due to the Exclusive Benefit Rule and the additional requirements noted above, dividing a 401(k) account balance between spouses via a QDRO is, in some ways, even more problematic than splitting up the benefits from a Defined Benefit Plan.

Because a participant’s separate property interest includes both contributions (employee deferrals and employer contributions) made before the date of marriage and earnings on those amounts, an accurate determination of how much of a current 401(k) account balance should be allocated to pre-marriage employment requires a detailed tracking of contributions and earnings by month from the date of marriage until the date of separation. In practice, this can be almost impossible because of the following factors:

1. Some 401(k) recordkeepers do not have systems capable of maintaining historical records sufficient to track
the monthly investment returns on each portion of a participant’s account balance required to do the calculation (e.g. employee pre-tax deferrals, post-tax employee contributions, employer match, discretionary profit sharing contributions etc.) where the participant may have chosen different investment options for each type of contribution

2. Tracking of historical account balances must also take into account any loans taken out and repaid by the participant before and during the marriage or any hardship withdrawals taken before separation.

3. Tracking must account for any rollovers that the participant may have made into the Plan from other Qualified Retirement Plans that the participant may have earned before the marriage but received and rolled into the current Plan during the marriage.

4. To the extent that the 401(k) Plan has been merged into another Plan (due to merger, acquisition, or divestiture of the employer), data maintained by the prior Plan sponsor may not have been preserved by the new recordkeeper.

5. Even in the absence of a merger or acquisition, the 401(k) recordkeeper may have changed, and the new recordkeeper may not have received all historical data from the prior recordkeeper.

Avoiding QDROs

In light of the above, it is our view that QDROs should
be avoided if at all possible. With respect to most defined benefit plans, this is only possible via a divorce settlement under which the participant spouse retains his/her entire pension benefit, and the non-participant spouse receives a greater share of other, more easily divided, marital assets.

As can be seen above, determining the value of any compensating additional marital assets to be provided to the non-participant spouse may still require detailed analysis that requires relatively high actuarial expertise.

There is, however, one approach that can provide divorcing couples with a far easier and less costly mechanism for explicitly dividing up Retirement Plan Benefits. Specifically, under IRC section 408, the participant may take a full distribution of his/her 401(k) balance and roll it over into an IRA, after which a “transfer incident to divorce” may take place11. In this approach, a negotiated portion of the IRA may be transferred to another IRA owned by the participant’s spouse. This transfer will not require a QDRO and can be implemented by the custodial trustee of the IRA at the direction of the two divorcing spouses.

This approach will, of course, require the divorcing couple to agree on an equitable division of the 401(k) account balance but avoids all involvement by the Plan sponsor, the recordkeeper, a QDRO expert, or an outside forensic accountant to validate the tracking discussed above. While primarily a solution for dividing up 401(k) balances, this technique can also be used in the case of a Defined Benefit or Hybrid Plan (e.g. a Cash Balance Plan) that provides for lump sum distributions that can be rolled over into an IRA

Concluding Thoughts

The division of qualified retirement benefits in long-duration marriages can be extremely complicated, and trying to do so directly using a QDRO can be very costly, time-consuming, and sometimes impossible to do with complete accuracy. With respect to defined benefits that do not allow for lump-sum distribution, allowing the participant spouse to keep his/her pension while providing a compensating- ing allocation of other marital assets to the non-participant spouse is far more financially efficient. In cases where the participant spouse’s retirement benefit is a 401(k) Plan or a Defined Benefit Plan that allows lump sum distributions, then a transfer to an IRA, with a subsequent division of the IRA “incident to divorce” should strongly be considered.

  1. Westrick-Payne & Lin , Age Variation in the Divorce Rate, 1990 & 2021 (2023) Nat. Center for Fam. & Marriage Research No. 16. (NCFMR Analysis of Centers for Disease Control and Prevention, National Center for Health Statistics, Vital Statistics & American Community Survey, 1-year estimates, 2021 (IPUMS-USA)) <https://www.bgsu.edu/content/dam/BGSU/ college-of-arts-and-sciences/NCFMR/documents/FP/westrick- payne-lin-age-variation-divorce-rate-1990-2021-fp-23-16.pdf> (as of Jan. 26, 2024).
  2. Int.Rev. Code, § 401(a)(2) & ERISA § 404(a)(1)(A).
  3. Treas. Reg. 1.401-1(b)(4).
  4. Int.Rev. Code, § 401(a)-13 (b) states that “a trust will not be qualified unless the plan of which the trust is a part provides that benefits provided under the plan may not be anticipated, assigned (either at law or in equity), alienated or subject to attachment, garnishment, levy, execution or other legal or equitable process.”
  5. Kuitkoff, What Expenses Can Be Paid from Plan Assets?, Am. Society of Pension Prof. & Actuaries (July 16, 2018) (a good summary of Department of Labor regulations regarding Settlor expenses) <https://www.asppa.org/news/browse-topics/ what-expenses-can-be-paid-plan-assets>(as of Jan. 26, 2024).
  6. Int.Rev. Code, § 414(p)(3)(A).
  7. Int.Rev. Code, § 414(p)(3)(B).
  8. Int.Rev. Code, §§ 414(p)(4)(A) & 414(p)(4)(B).
  9. Int.Rev. Service, Rev Rul. 79-336.
  10. Treas. Reg. 1.401-1(b)(1)(i).
  11. Int.Rev. Code, § 408(d)(6).

Actuary Peter J. Neuwirth FSA, FCA specializes in retirement plan issues. He is a 1979 graduate of Harvard College with a BA in Mathematics and Linguistics. After leaving Harvard, he went to work at Connecticut General Life Insurance, now CIGNA. For the next 38 years, he worked as an actuary in significant leadership positions at Aon, Hewitt Associates, Watson Wyatt, Towers Perrin, and Towers Watson. He spent five years as a chief actuary at Godwins, seven years at Coates Kenney, and a year at Price Waterhouse. In 2016, Pete retired to focus on writing and researching financial wellness issues, including using home equity to generate retirement income. His two current books include Money Mountaineering: Use the Principles of Holistic Financial Wellness to Thrive in a Complex World and What’s Your Future Worth? Using Present Value to Make Better Decisions. Pete is a Fellow of both the Society of Actuaries and the Conference of Consulting Actuaries and is a frequent speaker at conferences around the country on both retirement income strategies and the challenge of using QDROs to facilitate divorce among older couples.

Attorney Barry Sacks PhD, JD earned his Ph.D. in semi-conductor physics from M.I.T., then taught at U.C. Berkeley. He earned a J.D. from Harvard Law School and is a Certified Specialist in Taxation Law from the California Board of Legal Specialization. After spending 35 years as an ERISA attorney specializing in qualified retirement plans and IRAs, he focused on developing a strategy to enable retirees to manage the retirement income from these plans optimally. With his brother, Professor Stephen Sacks, Barry published the pioneering research paper model- using reverse mortgage credit lines as buffer assets to mitigate the effects of adverse sequences of investment returns in retirement accounts. His current research focuses on using reverse mortgages to facilitate divorce settlements among older couples.