A property division primer: QDROs, 401(k)s and taxes

As you may already know, Texas is one of only a handful of states that follow community property rules in the area of property division. This means that a family court will generally divide any property secured during the course of the marriage on a 50-50 basis. This, of course, is decidedly different from equitable division states, where a family court will examine multiple factors and divide marital property in what it believes to be a fair manner.

It’s important to understand, however, that depending on the circumstances of the individual case, family courts here in Texas do have the ability to divide martial property in what could be deemed an equitable manner.

To illustrate, one area where courts will exercise this ability is the division of employer-run retirement accounts such as 401(k)s, which often hold a significant share of martial assets.

Regardless of whether the family court decides to split assets held in a 401(k) account directly in half or orders what it believes to be a more equitable split, it’s important to understand that this division could present potential tax consequences.

If a court orders the division of 401(k) assets or future benefits, a qualified domestic relations order will need to be secured.

In essence, a QDRO is a court decree that reassigns/re-titles 401(k) assets in the former spouse’s name, essentially providing them with the right to receive either a set number of payments from the retirement account or a set percentage of the balance retirement account. It is generally included in the final divorce decree.

The primary purpose of the QDRO is that it enables the spouse named as the owner of the 401(k) account to transfer funds to their former spouse without incurring the 10 percent early-withdrawal penalty. It also enables the former spouse receiving the funds to roll them over into an individual retirement account tax-free.

It must be noted, however, that the standard tax rules apply to any distributions made after the transfer of funds via the QDRO. In other words, once the former spouse has the funds secured in an IRA and then decides to withdraw some of them early (prior to the age of 59-and-a-half), they will incur the early withdrawal tax.

Given the complexity associated with the division of retirement accounts, divorcing spouses should strongly consider consulting with an experienced legal professional to learn more about their rights and their options.

Source: Forbes, “Taxes from A to Z (2014): Q is for QDRO,” Kelly Phillips, March 31, 2013; The Wall Street Journal, “If divorcing, divide investments with care,” Lisa Ward, April 6, 2014