Retirement plan benefits, like 401k accounts and pension benefits, are often divided in a Texas divorce as part of the property division. Retirement benefits often represent one of the largest assets in the marriage (along with the house and cars). Their division may play an important role in fairly dividing the marital property between the spouses. Most retirement plans are subject to federal laws that become entangled with the division in the divorce. The property division in the divorce is governed by state law (Texas Family Code). The retirement plan itself undoubtedly also has specific rules that relate to how the division will occur.
This web of rules and regulations makes dividing the retirement plan a challenge for the divorce as well as the post-divorce qualified domestic relations order (QDRO). A QDRO orders the retirement plan administrator to execute the division of benefits. The QDRO itself can be such a complex document that many divorce lawyers will not draft them.
Start thinking about QDROs early in your Texas divorce
Early in the divorce the parties should begin to analyze retirement benefits to determine how they will fit into the property division. The parties and their divorce attorneys should obtain information about the value of benefits, types of retirement plans involved and the specific rules that may play a role. It is extremely important to understand the type of retirement plan associated with a specific benefit. The plan type will determine how to divide the benefit and how to receive those funds.
Failing to understand this distinction early in the divorce can set up the parties to negotiate with incorrect understandings. The property agreement may not work out because the plan prohibits the terms of the settlement. That can be a tremendous waste of time and money. Let’s avoid that and discuss the two primary forms of retirement plans divided in a divorce.
Defined Contribution Plans and QDROs in Texas
Defined contribution plans are today the most common structure for employer-sponsored retirement plans. They include retirement plan such as 401k plans, 403b plans, ESOPs, 401a money purchase plans and (most) profit sharing plans. Defined contribution plans are just that. The funds contributed to the plan are defined but the benefit received when the employee retires is undefined. Instead, the participant receives whatever benefit the plan produces from gains or losses plus contributions made by the employee and employer. In a defined contribution plan the benefit funds when the plan receives the funds.
Dividing a defined contribution plan is easier than defined benefit plans. We can readily determine the value of the participant’s benefit on the date of divorce to divide the benefit. No complicated formula is usually necessary. It’s just the value of the assets attributed to the participant on that date.
Most defined benefit plans also permit a lump sum distribution. They set up their QDRO procedures to allow the alternate payee to take an immediate payment so the division is relatively simple. We just need to determine what portion of the benefit to divide in the divorce. The alternate payee can receive that divided sum in full (less any tax withholding).
Formulas to divide defined contribution retirement plans in a Texas divorce
There are two formulas to divide a defined contribution benefit in a divorce. The first formula is incredibly easy. The QDRO can state a specific dollar amount paid to the alternate payee. So long as the stated amount is available then that is what the plan administrator will do. There is no further calculation to perform.
The second formula is slightly more complex but still not very difficult. The plan administrator will take the value of the participant’s benefit on the date of divorce and the value of the benefit on the date of marriage and subtract the value on the date of marriage from the date of divorce to determine the benefit accrued during the marriage. The QDRO will then instruct the plan administrator to give the alternate payee a specific percentage of the benefit accrued during the marriage. It might be 50% or it could be anywhere from 1% to 100%. That is generally how it works.
Defined Benefit Plans and QDROs in Texas
Defined benefit plans are what most people think of when they hear the word “pension” although under federal law the term pension applies to both defined benefit and defined contribution plans. In a defined benefit plan the participant receives a defined benefit amount at a specific retirement age based upon the plan’s benefit formula. Often this formula is based upon the participant’s wages and years of service with the plan.
These plans receive funding, usually only by the employer, but the employer’s obligation is to pay the defined benefit rather than a defined contribution. The employer will fund the pension plan’s trust generally to satisfy its obligations to its employees and retirees. In a defined benefit plan the plan formula can produce estimates of the employee’s likely benefit at the specified retirement date. The benefit is not certain until retirement age and the plan has all the employee’s service and wages.
An added complexity to these plans are the ways the plans pay out benefits. All defined benefit plans offer annuity forms of payment in which the participant receives periodic payments. The plan may also offer various alternative annuity options that make survivor payments to a spouse or other beneficiary or adjusts the payment amount to front-load benefit payments. Many plans also offer lump sum payments in which a single payment will satisfy the full benefit owed to the participant. Some plans also permit early retirement so employees who leave the company before the plan’s normal retirement age can take early payment, often after suffering a reduction in benefits to account for the early payment.
Challenges to dividing defined benefit plans in a Texas divorce
When assembling these plan rules it becomes a far more complex formula than the defined contribution plans. We must account for the plan’s payment options and timing of permitted distributions. Under a defined benefit plan we often cannot request division of a fixed dollar amount. The employer just has a future obligation to pay that defined benefit.
Instead, we have to determine the amount of that future defined benefit earned during the marriage and then divide it by assigning a percentage of the marital portion to the alternate payee. Our work here is less specific because we are not working with actual valuations from the dates of marriage and divorce but instead estimates that may ultimately change in the future. There are also a long list of variables that can affect how we ask the plan administrator to determine the marital portion and divide the benefit.
In addition to dividing the normal benefit, there may be ancillary benefits that affect the division. These may include separate death benefits and pre-retirement survivor benefits. Many times the alternate payee’s benefit may be stuck to the participant’s decision to retire. (So that the alternate payee cannot receive his or her share until the participant retires.) The alternate payee may be able to limit the participant’s payment option to protect his or her share. As you can see, dealing with defined benefit plans are far more complex and murky. This even causes many divorce attorneys to get lost dividing retirement benefits and drafting a QDRO. It is too easy to let a handful of words cost thousands or even tens of thousands of dollars.
One Major Mistake…
The time to start figuring out these issues is early in the divorce. One major mistake a lot of people make–even divorce lawyers–is agreeing to a division of retirement benefits without first figuring out the relevant plan rules and the available benefits. This mistake can waste time and money. However, this mistake becomes substantial once the judge signs the decree.
Once the divorce decree is signed there are limited opportunities to change the language to account for the plan rules. That makes correcting the decree problematic. It may leave one party in a financial position they did not expect or leave benefits undivided. Sometimes the award in the divorce decree is unenforceable, even with a QDRO. So the award is basically worthless. When it’s not worthless the alternate payee will have to chase down the participant to try to get satisfaction.
Problems after the QDRO in a Texas divorce
Aside from the financial burden of not following the QDRO process, the 401k account holder can get himself or herself in trouble by taking money out of the plan and giving it to the other person. In some rare situations, the alternate payee attempts to double dip against the account holder. The divorce decree will call for a division of assets; but rather than insisting on the QDRO, the account holder will take the money out and give it to the alternate payee. The alternate payee will take the money and then go get the DRO.
Now, obviously, the account holder should have given the alternate payee a check and proving the check was cashed is not terribly difficult but the account holder may spend a lot of unnecessary money offering that proof. You don’t need to pay the taxes on the distribution and then have to go back to court to prove you paid the funds to your ex-spouse. I’ve seen situations where the court issued the DRO after the account holder paid cash to the alternate payee and then the plan complied with the DRO and paid out the other half of the account to the alternate payee. Don’t put yourself at risk for that situation. A QDRO is your friend.