QDRO

Nov 2022 : Use of QDRO Funds to Pay Spousal Support and Receive a “Disparity in Brackets” Tax Benefit

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

As is widely known, spousal support was previously taxable to the recipient and deductible by the payer. However, pursuant to the Tax Cuts and Jobs Act of 2017, alimony payments provided in divorce documents executed after January 1, 2019 are no longer taxable/deductible.

When they were taxable/deductible, the parties could take advantage of a disparity in tax brackets, hence “whipsawing” Uncle Sam, as follows:

  • H is required to pay W spousal support of $5,000 a month – $60,000 a year – for 5 years.
  • H is in a 40% combined federal & state tax bracket; W’s combined bracket – 20%.
  • On an annual basis, the payments and taxation thereof were as follows:
    • Payment Tax/Tax Savings Net of Tax
      H (60,000) 24,000 (36,000)
      W 60,000 (12,000) 48,000
    • So, because of the disparity in brackets, it cost H $36,000 to provide W $48,000. Uncle Sam pitched in the additional $12,000.
    • Multiply this by five years and the “tax subsidy” was $60,000.

Though no longer available due to the change in the law, the tax benefit from a disparity in tax brackets can still be achieved by use of a QDRO for a defined contribution plan – such as a 401(k) plan.

For example, assume the same facts as above – including H’s and W’’s respective tax brackets.

  • H & W sign a QDRO providing that his 401(k) plan pay W $60,000 a year.
  • W will pay $12,000 tax on the $60,000, netting her $48,000.
  • The payments are not subject to the 10% early withdrawal penalty regardless of W’s age under IRC Section 72(t).
  • H has used pre-tax funds to satisfy his spousal support obligation.
  • He has effectively shifted the tax on $300,000 – on which he would ultimately be taxed at his 40% bracket – to W at her lower 20% bracket.

Observations

  1. In situations where there are (1) a meaningful disparity in tax brackets; (2) a spousal support obligation; and, (3) the payer has a 401(k) savings plan, consider
    using a QDRO to shift the incidence of tax from the high bracket payer to the low bracket payee.
  2. This cannot be done, however, by transferring the entire amount – $300,000 in the example – which the payee would roll into an IRA.
    Reason – once transferred to an IRA, withdrawals are subject to the 10% penalty tax if the withdrawing party is under age 59 and a half.

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… “Use of QDRO Funds to Pay Spousal Support and Receive a “Disparity in Brackets” Tax Benefit”
View / Download November 2022 Article – PDF File

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

Read More “Nov 2022 : Use of QDRO Funds to Pay Spousal Support and Receive a “Disparity in Brackets” Tax Benefit”

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

Posted by Joseph W. Cunningham, JD, CPA

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)

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

Nov 2019 : QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

With the elimination of taxable/deductible Section 71 payments effective January 1, 2019, using a QDRO transfer of an interest in a defined contribution plan (e.g., 401(k), 403 (b) account) by which a business owner spouse buys out the other spouse’s marital interest is a good fit in many situations.

General

In the past, Section 71 payments provided a means by which one spouse could buy out the other’s marital interest in a business with pretax dollars. But, with the 2017 Tax Cuts and Jobs Act of 2017 repeal of the alimony deduction, this method is no longer available as of January 1, 2019.
However, use of a transfer of an interest in a defined contribution plan account via a QDRO can be a “tax-smart” way to structure a business buy-out.

Example

  • H, 45 years old, owns ABC Company (ABC) which has been valued at $250,000 for his and W’s divorce settlement.
  • However, there are not sufficient other suitable marital assets to award W to offset the $250,000 business value.
  • But, H has a 401(k) account with a balance of $400,000.
  • His tax savvy lawyer proposes that H use his half of the 401(k) account to buy out W’s $125,000 interest in the business.
  • He tells H that he has the (1) business and (2) many years to replenish his 401(k) account for his future security.
  • He adds that, by using the 401(k) account, He will not need to use his personal cash or that of ABC for the buy-out.
  • Further, he states, since W no longer has the business as part of her future security, receiving additional 401(k) funds is ideal for her.
  • Since the $250,000 business value is largely after-tax and the 401(k) account is 100% pre-tax, the transfer to W must be tax affected.
  • So, assuming W federal and state tax rate will be 20%when she draws the 401(k) in the future, H transfers via a QDRO $156,250 of his $200,000 share of the 401(k) to W, the equivalent of $125,000 after-tax.

Observations

  1. Avoiding using cash for the buy-out may be particularly beneficial if H has spousal and/or child support obligations.
  2. Use of part of a 401(k) can also be used to buy-out an alimony obligation, as follows:
    • The present value of the projected stream of spousal support payments is calculated.
    • Then, the 401(k) amount is tax affected at the recipient’s tax bracket to its after-tax equivalent similar to what was done in the example.
    • The recipient can access the transferred amount from the 401(k) without the 10% penalty regardless of either parties’ age.

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… “QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions”
View / Download November 2019 Article – PDF File

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

Read More “Nov 2019 : QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions”

Aug / Sept 2017 : In a Published Case, Court of Appeals Approves Entry of QDRO 12 Years Post Date of Divorce–JOUGHIN, No. 329993 (7/11/2017)

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Facts

  • H and W were divorced on April 28, 2003.
  • The Judgment of Divorce (JOD) awarded W (1) 50% of H’s pension accrued as of April 30, 2002 and (2) $23,823 from his profit-sharing plan account.
  • The JOD provided that both parties “shall cooperate” in obtaining and processing the QDROs necessary to effectuate the transfers to W.
  • For reasons not apparent on the record, the QDROs were not promptly filed. Instead, W submitted the QDROs for entry with the trial court on June 30, 2015- more than 12 years post-divorce.
  • H objected claiming that W’s submission of the QDROs for entry was an attempt to enforce the 2003 JOD and, hence, was time-barred under MCL 600.5809(3), which provides a 10-year statute of limitations applicable to attempts to enforce a noncontractual money obligation.
  • W responded that because her claim did not arise until H reached retirement age, that the statute had not yet begun to run.
  • Because H had not retired nor received any of his retirement benefits, the trial court entered the QDROs.
  • H appealed.

Court of Appeals Decision

  • The Court disagreed with the parties’ position that MCL 600.5809 applied to entry of a QDRO.
  • Rather, the Court cited a previous decision that “when a judgment of divorce requires a QDRO to be entered, the QDRO is to be considered as part of the divorce judgment.”
  • Accordingly, the Court stated that “because the QDRO is part of the judgment, it necessarily cannot be viewed as enforcing the same judgment.” *** “Instead, we hold that under these circumstances, the act to obtain entry of a proposed QDRO is a ministerial task done in conjunction with the divorce judgment itself.”
  • Thus, the Court concluded that entry of the QDROs was not time-barred
  • Judge Kathleen Jansen wrote a vigorous dissent claiming, for various reasons, that entry of the QDRO after 10 years was barred by the statute of limitations.

Comments on the Case

  • Obviously, the case is a “poster child” for the importance of preparing and processing QDROs promptly – either contemporaneous with entry of the divorce judgment or soon thereafter.
  • Based on many years’ experience of preparing QDROs for legal aid clients under a pro bono program administered by the State Bar, QDROs unfiled for years following divorce are not uncommon. This case – a rare family law published case – indicates that the passage of 10 years or more does not bar entry of a QDRO.
  • However, in Joughin, the participant had not begun to receive benefits. Had he done so, or remarried, or died, the situation would likely have been much more problematic for the alternate payee.
  • And, the Joughin judgment provision reprinted in the Court’s opinion did not provide that W’s share of H’s profit-sharing plan account would be adjusted proportionately for gains or losses of plan investments. With the sharp advance of the stock market from 2003 through 2015, W paid a high price for not timely attending to the QDROs.
  • In this regard, there is no precedent regarding whether the right to receive a proportional share of plan gains and losses passes automatically under state law with the transfer via QDRO of an interest in an account balance plan such as a 401(k) or profit-sharing plan as in Joughin.
  • Unless transferring a set dollar amount, it is highly advisable to include such a provision in both the JOD and the QDRO.

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 PDF file below… “In a Published Case, Court of Appeals Approves Entry of QDRO 12 Years Post Date of Divorce–JOUGHIN, No. 329993 (7/11/2017)”
View / Download Aug-Sept 2017 Article – PDF File

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

Read More “Aug / Sept 2017 : In a Published Case, Court of Appeals Approves Entry of QDRO 12 Years Post Date of Divorce–JOUGHIN, No. 329993 (7/11/2017)”