Apr 2022 : Flexible Use of Funds in a Defined Contribution Plan E.G. – 401(K) – Received Via a QDRO in a Divorce Settlement

View / Download April 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Receipt of an interest of a defined contribution (DC) plan pursuant to a QDRO can provide funds to serve many purposes on a relatively low-cost basis. DC plans are also referred to as “account balance” plans.

First, most such assignments of an interest in a DC plan – such as a 401(k) or savings plan – can be drawn as a lump sum distribution.

Second, such distributions are not subject to the 10% federal penalty tax applicable to distributions payable to someone under 59.5 years old.

Third, the recipient of such a distribution has 3 options regarding the funds:

  1. Pay regular tax on the distribution.
  2. Roll the distribution into an IRA – either existing or newly created – so that the funds can grow tax-free until later drawn out, usually at retirement
  3. A combination of options 1 and 2 – that is, pay tax on part of the distribution while rolling the balance into an IRA.

The above sets the stage for some creativity when there is a need for cash.

Example 1

  • The wife (W), 40 years old, receives $50,000, half of H’s $100,000 401(k) account balance, via a QDRO assignment.
  • She needs $15,000 to pay her attorney.
  • So, she rolls $32,000 into an IRA, pays $3,000 tax on the other $18,000, netting the $15,000 she needs for attorney fees.

Example 2

  • H and W owe $20,000 of credit card debt.
  • W has a $100,000 401(k) account balance.
  • She transfers $62,500 to H via a QDRO, retaining $32,500.
  • Their divorce settlement provides (1) that H is solely obligated to pay the credit card debt; (2) that he will do so within 5 business days of receiving the 401(k) distribution; and (3) that he will provide documentation of the payment to W within 5 days thereof.
  • H rolls $32,500 into an IRA, pays $5,000 tax on $25,000, netting the $20,000 needed to pay the credit card debt.

The above are simple examples of strategic use of DC plan funds in a divorce settlement. The uses are as varied as the cash needs of divorcing parties – such as a down payment on a new condominium, paying student loans, college expenses, etc.

It is noteworthy that:

  • Once DC plan distribution funds are rolled into an IRA, they are no longer exempt from the 10% penalty tax if withdrawn before age 59.5.
  • Regarding rolling some or part of a distribution into an IRA, it is highly advisable to arrange in advance for a “trustee-to-trustee” transfer directly from the plan into the IRA.
  • DC plans will generally withhold 20% federal tax on lump sum distributions. This can be avoided if a “trusteeto- trustee” transfer is arranged in advance.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Flexible Use of Funds in a Defined Contribution Plan E.G. – 401(K) – Received Via a QDRO in a Divorce Settlement”
View / Download April 2022 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Mar 2020 : Provisions of the 2019 SECURE Act Relevant to Family Law

View / Download March 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


The SECURE Act of 2019

General

The SECURE Act was signed into law on December 20, 2019. “SECURE” is an acronym for “Setting Every Community
Up for Retirement Enhancement.” Most of its provisions (1) expand opportunities for accumulating retirement bene/ts
and (2) take e0ect January 1, 2020.

Penalty Free Withdrawals from 401(k)s and IRAs for Child Care Expenses

Under the SECURE Act, a parent expecting a child – including a newly adopted child – may withdraw up to $5,000 from a 401(k) account or an IRA to cover expenses associated with the child without incurring the 10% penalty tax on early withdrawals (generally, withdrawals before 59 1/2 years of age). For married couples, up to $10,000 can be withdrawn penalty-free.

Such withdrawals are still subject to regular federal and state income tax. And, of course, such withdrawals result in that much less growing tax-free for retirement.

But, for relatively young parents in a relatively low tax bracket, accessing funds to cover new child expenses can be quite beneficial.

And, for anyone adopting a child, the extra funds can offset some of the significant costs of adoption.

Use of 529 Plan Funds to Pay Student Loans

Internal Revenue Code Section 529 allows states to establish tax-advantaged savings programs that allow contributions to an account for a designated beneficiary’s qualified higher education expenses (QHEE).

Michigan has established the Michigan Education Savings Program (MESP) – a Section 529 program.
Distributions from such accounts – including earnings – are not taxable provided such distributions do not exceed the
beneficiary’s QHEE.

QHEE include tuition, fees, books, supplies, and equipment – including technology equipment – required for attendance at a qualified institution of higher education (as defined in the 1998 Amendment to the Higher Education Act of 1965 – generally, any public college or university).

Distributions for QHEE are limited to $10,000 per beneficiary annually. If there is more than one Section 529 account for a beneficiary – e.g., one maintained by each set of grandparents – the $10,000 limit applies to distributions from all accounts on a combined basis.

The SECURE Act expands QHEE to include payments on student loans. .is can be particularly beneficial if there is a balance in a 529 account when a student completes his/her education and has student loan debt – a not uncommon occurrence. The 529 funds can be used to pay the student loan. However, such payments are limited to $10,000 annually.


About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Provisions of the 2019 SECURE Act Relevant to Family Law”
View / Download March 2020 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Oct 2019 : Taking Taxes Into Account In Property Settlement Involving “Pre-Tax” Assets – Huggler v Huggler, Mich App. No. 343904 (6/25/19)

View / Download October 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Facts

  • Of their marital estate of around $800,000, the parties agreed as follows:
W H Total
Real Estate, Investments, Bank Accounts, and Personal Property 71,488 384,929 456,417
Retirement Assets – Pre-Tax 273,896 71,488 345,384
  • Because W was to receive a disproportionate amount of pre-tax assets, they further agreed that (1) H would pay W $154,618 of “Non-Retirement Assets” and (2) W would assign to H via a QDRO $101,204 from her retirement assets.
  • This would result in the following equal division of pre-tax retirement benefits:
W H Total
Real Estate, Investments, Bank Accounts, and Personal Property 226,106 230,311 456,417
Retirement Assets – Pre-Tax 172,692 172,692 345,384
  • Notwithstanding this agreement, H and W disagreed as to how the $154,618 balancing payment would be made. W wanted to receive the $154,618 in non-retirement assets. But H wanted to pay her $54,618 in cash and net the other $100,000 against the $101,204 retirement transfer due him from W.
  • W objected because it would leave her with a disproportionate share of pre-tax assets, as follows:
W H Total
Real Estate, Investments, Bank Accounts, and Personal Property 126,106 330,311 456,417
Retirement Assets – Pre-Tax 272,692 72,692 345,384
  • W claimed that she intended to access the $100,000, which in doing so would result in both income taxes and a penalty tax leaving her considerably less than what she had coming per the agreement.
  • She stated that she would “incur predictable and foresee-able tax penalties to cash in the retirement funds.”
  • The trial court ruled in H’s favor ruling that it would not consider the tax consequences of the division of assets be-cause “it would be forced to speculate when – or even if – she would cash in the accounts.”
  • W appealed.

Court Of Appeals Decision

The Court upheld the trial court decision, ruling in part that W “had not established that the tax consequences were reasonably likely to occur and were not merely speculative.”

Comments On The Case

1. General Practice in Michigan—Michigan family law judges do not typically reduce the value of assets by future tax unless the tax is imminent or otherwise not subject to speculation.

Nor are they required to, as the Court stated, under Nalevayko v Nalevayko, 198 Mich App 163 (1993).

2. Pre-Tax Assets – But, certain assets – employee benefits such as 401(k) accounts, IRAs (other than Roth IRAs), bonuses, and various forms of incentive pay – (1) are certain to be taxed and (2) generally provide no benefit to the employee spouse until he or she squares off with Uncle Sam and pays the tax.

Thus, unlike other investments, real property, and closely-held businesses, the various forms of retirement benefits and employee/executive compensation are generally tax affected for divorce settlement to the extent they are not divided equally.

Not to do so would result in an inequitable settlement to the party receiving more than half of pre-tax benefits, such as W in Huggler.

Simple Example – If one party receives a $10,000 bank account and the other a $10,000 pre-tax IRA, the divi-sion is not equal. Before the IRA funds can be converted to spendable cash, a tax must be paid resulting in a net amount of considerably less than $10,000.

3. Calculation of the Tax – The calculation of the tax can, however, be subject to dispute.

One approach is to allocate a portion of the total tax on a pro rata, or proportional, basis – the Average Tax method.

Another is to calculate the tax resulting from adding subject benefits on the tax return – the Marginal or Incremental Tax method. This calculation usually involves (1) calculating tax with the benefits included and (2) running the calculation without them. The difference is the tax attributable to the benefits.

The theory supporting the Average Tax method is that who is to say what component – or layer – of income is taxable at the lower rates on the tax rate schedule and which are taxable at higher rates. Hence, using an aver-age rate is fair – treating all dollars of income the same. It seems the average rate approach is better suited to elements of income routinely received by and taxable to the taxpayer spouse – such as a bonus received each year.

Correspondingly, the marginal approach seems more apt for items not part of the annual pay package, such as stock options issued periodically or, certainly, severance pay.

Illustration

Taxable Income Assuming:
Basic Comp Only Add Non-Recurring Incentive Pay Total
Taxable Income 100,000 50,000 150,000
Federal Tax (Rounded) 35,500
Average Tax Rate 23.7%
Marginal Tax Rate 28%
Tax Affected Value of $50,000:
– Less average tax: 50,000 – (23.7% x 50,000) = 38,150.
– Less marginal tax: 50,000 – (28% x 50,000) = 36,000.

And, of course, the difference is more dramatic if larger non-recurring benefits result in taxation at the top rate of 37%, vs. 28% in the example.


About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Taking Taxes Into Account In Property Settlement Involving “Pre-Tax” Assets – Huggler v Huggler, Mich App. No. 343904 (6/25/19)”
View / Download October 2019 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Aug / Sept 2019 : Bankruptcy Exemption May Not Apply To Retirement Benefits Received In Divorce – Lerbakken v Sieloff & Associates, PA, NO. 18-6018 (8th Cir. 2018)

View / Download Aug-Sept 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Background

  • In his 2014 divorce settlement, Mr. Lerbakken (Mr. L) received half of his wife’s 401(k) account and 100% of her IRA.
  • He subsequently filed for bankruptcy protection. One of his creditors was Sieloff & Associates. The firm that handled Mr. L’s divorce and remained unpaid.
  • Mr. L claimed that the 401(k) account and the IRA received in the divorce were exempt from claims of creditors as retirement assets under 11 U.S.C. Section 522(d)(12).
  • The bankruptcy court disallowed Mr. L’s claimed exemption for the 401(k) and the IRA.
  • Mr. L. appealed to the 8th Circuit Court.

8th Circuit Court Ruling

  • The 8th Circuit Court (Court) upheld the lower court’s disallowance of the exemption.
  • The Court referred to a 2014 U.S. Supreme Court ruling that an inherited IRA did not qualify as a retirement asset qualifying for the bankruptcy exemption. Clark v Rameker, 134 SCt 2242 (2014).
  • In so ruling, the United States Supreme Court indicated that retirement funds for purposes of the bankruptcy exemption meant funds set aside to be available when one stopped working and, hence, did not apply to an inherited IRA.
  • The Court ruled that a retirement asset received as part of a property settlement does not qualify for the exemption either.
  • The Court was not swayed by Mr. L’s claim that his wife’s 401(k) and IRA were accumulated specifically for their joint retirement.
  • It was also noted that Mr. L had not rolled the assigned funds into his own retirement account. He could not even produce a QDRO indicating that he had accessed his as-signed share of the 401(k).

Comments on the Case

  • The Court seemed to narrowly construe the statute since, as Mr. L asserted, the funds in question were in fact set aside for his and his former wife’s retirement.
  • The division of the parties’ retirement assets is frequently done with the objective of providing each party with sufficient financial security for retirement years.
  • Where bankruptcy is a possibility, to lessen the chances of what happened to Mr. L, retirement funds received in a divorce should be accessed promptly and rolled into one’s own retirement account.
  • QDRO preparation and processing should be attended to forthwith after a divorce.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Bankruptcy Exemption May Not Apply To Retirement Benefits Received In Divorce – Lerbakken v Sieloff & Associates, PA, NO. 18-6018 (8th Cir. 2018)”
View / Download Aug-Sept 2019 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

May 2015 : Overview of the Division of Retirement Benefits in Divorce – Part 2

Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

The following is a continuation of the materials presented in the March 2015 Tax Trends column.

III. Defined Contribution (DC) Plans

  1. A DC plan–such as a 401(k) plan – provides for separate account for each participant.
    1. E.g.–W’s account balance under the XYZ 401(k) plan was $50,000 on December 31, 2014.
    2. Other types of DC plans include pro t-sharing plans, money purchase pension plans, and 403(b) annuities.
  2. Division of DC plan accounts is also accomplished either by the o set method or by deferred division using a QDRO/EDRO.
  3. Offset method – Valuation
    1. The present value of the DC plan interest is generally considered its account balance as of the valuation date. See above for an example.
    2. As with the present value of pensions under DB plans, it is typically appropriate to tax affect the value of the account balance.
    3. It is important to specify a valuation date, generally close to when other assets will be divided.
    4. If there is a plan loan, the account is (1) valued net of the loan and (2) responsibility to repay the loan is assigned to the participant.
      Example:

      • The total pre-tax value of W’s 401(k) account is $50,000 – $40,000 of plan investments and (2) a $10,000 loan she drew from the plan.
      • Equal division under the offset method:
        (Table shown in PDF)
  4. Deferred division method – QDROs/EDROs

Continued in PDF file below… “Overview of the Division of Retirement Benefits in Divorce – Part 2”
View / Download May 2015 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)