HOW TO HANDLE QUALIFIED DOMESTIC RELATIONS ORDERS (QDROs) David Rhett Baker, J.D. David Rhett Baker, P.A. Orlando, FL davebaker at benefitslink.com January, 1995 I. CONTEXT II. PLAN ADMINISTRATION CONCERNS III. PROCESSING THE INCOMING ORDER IV. IMPROVING THE PROCESSING OF INCOMING ORDERS V. RESTRICTIONS ON TIMING OF PAYMENTS TO THE ALTERNATE PAYEE VI. POSSIBLE ISSUANCE OF REGULATIONS BY DOL VII. ALTERNATE PAYEES AND DISCLOSURE REQUIREMENTS VIII. ALTERNATE PAYEES AND INCOME TAXES I. CONTEXT Tension between (i) anti-alienation rules of the Code and ERISA, and (ii) wanting to allow ex-spouses, children and other dependents access to plan assets to satisfy domestic relations liabilities of plan participants. QDRO statute came into the Code and ERISA as part of the Retirement Equity Act of 1984, the Act that included other major spousal rights legislation: mandatory joint and survivor annuities at retirement. II. PLAN ADMINISTRATION CONCERNS A. Avoid disqualification of the plan due to violation of the anti-alienation rule. IRS has ruled that the pledge of a participant's benefit as security for the participant's obligations under a divorce property settlement is a permissible type of "assignment" under a QDRO. PLR 9234014 (May 21, 1992). The ex-husband agreed to indemnify his ex-wife in the event of certain tax obligations (probably stemming from their joint tax returns). B. Protect participants' retirement benefits to the extent possible. (Encourage the ex-spouse or other plaintiff to satisfy the domestic relations liabilities from non-retirement assets.) C. Minimize liability. 1. Avoid a contempt order from the state court judge. a. State courts have concurrent jurisdiction with federal courts in the determination of whether a particular order constitutes a QDRO within the meaning of the Code and ERISA. Board of Trustees of the Laborers Pension Trust Fund for Northern California v. Levingston, 816 F. Supp. 1496 (N.D. Cal. 1993) (federal court refused to grant injunction to prevent state court's order from becoming effective; plan should have opposed in state court). b. Don't let the parties "stipulate" that the order constitutes a QDRO. Oppose language in a proposed order that states outright that the order is a "qualified domestic relations order," though language that the order is intended to be a qualified domestic relations order is fine. c. On the other hand, the plan does not have to second-guess the court. In ERISA Opinion Letter 92-17A (Aug. 21, 1992), the DOL said a plan was justified in complying with the terms of a state court order in which the judge determined the participant's former wife constituted an alternate payee despite their having obtained an annulment of the marriage. The Plan Administrator pointed out in its request for an opinion that the participant had been married 39 years and had six children before the annulment. "It is the view of the Department that the plan administrator is not required by section 206(d)(3) or any other provision of Title I to review the correctness of a determination by a competent State authority that an individual is a "spouse," "former spouse," "child," "other dependent" or "surviving spouse" of the participant under state domestic relations law. The DOL said the definition of those terms was a matter of State law, although the question of whether an order is a qualified domestic relations order is a matter of federal law. (Ibid. at fn. 2.) d. Some marital property issues are out of bounds, however. The DOL ruled in Advisory Opinion 90-46A (Dec. 4, 1990) that a state court order would not constitute a QDRO where the reason for the order was the death of a plan participant's spouse and an attempt by the estate to obtain a one-half community property interest in the participant's benefit. The state's community property laws were preempted by ERISA, said the DOL, and the exception from ERISA preemption provided for QDROs was intended to permit state laws to control plan assets only for alimony, property settlement and similar orders issued in domestic relations proceedings. 2. Avoid threat of sanctions from attorney for ex-spouse in federal lawsuit (e.g., payment of attorney's fee in securing injunctive order requiring plan to comply with ERISA requirements in the processing of the order). 3. Avoid liability to the participant for wrongful payment of the participant's benefits or wrongful withholding of benefits while order is being processed. D. Comply with additional reporting and disclosure requirements that apply to alternate payees. E. How to treat the alternate payee with respect to various plan features available to plan participants: direct rollovers, self-direction of investments, loans, hardship distributions, privilege of naming a beneficiary with respect to undistributed amounts at death. III. PROCESSING THE INCOMING ORDER A. Plan must have a written QDRO procedure in place. ERISA section 206(d)(3)(H). Required contents of that procedure: 1. How the qualified status of a domestic relations order will be determined 2. How distributions per such orders will be administered 3. Must require the plan to provide notice to the alternate payee and the plan participant of the QDRO procedure "promptly" upon receipt of the order 4. Must permit an alternate payee to designate a representative for receipt of copies of any notices that are sent by the plan regarding the order B. Does the order qualify as a QDRO? Checklist: 1. Is the order a domestic relations order? An order is a domestic relations order if it is a judgment, decree, order or approval or a property settlement that: (a) relates to the provision of child support, alimony payments, or marital property rights to a spouse (present or former), child or other dependent of a participant; and (b) is made pursuant to a state domestic relations law, including a community property law. A property settlement agreement that has not been approved by a court is not a domestic relations order. 2. Does the order contain the name of the plan(s) to which it applies? 3. Does the order create or recognize the rights of one or more alternate payees (other than the participant) to receive all or part of the participant's plan benefits? 4. Does the order contain the name and last known mailing address of the participant? 5. Does the order contain the name and mailing address of each alternate payee covered by the order? 6. Does the order specify the amount or percentage of the participant's benefit to be paid by the plan to each alternate payee, or the manner in which such amount or percentage is to be determined? 7. Does the order specify the number of payments or the period to which such order applies, for example, the date on which the assignment is to be made? 8. Does the order only require benefits at a time or in a form that is available under the plan document? 9. Does the order only require the plan to provide benefits that do not exceed the participant's plan benefits? 10. Does the order refrain from affecting any benefits of a prior known QDRO with respect to this participant? C. Common mistakes made in drafting attempted QDROs: 1. It is not a domestic relations order. Example: a judgment creditor seeking to recover on a debt. 2. It requires a form of benefit not otherwise provided by the plan, especially due to the timing of the commencement of the benefit. Example: the order requires the plan to begin payments to the alternate payee prior to the time a participant could commence receipt of payments, unless the participant has attained his or her "earliest retirement age," as defined below. 3. It fails to include one of the required pieces of information, such as the name of the plan, the name and last known address of the alternate payee or the name and last known address of the participant. 4. It is ambiguous as to the "amount or percentage of the participant's benefits to be paid by the plan." Code section 414(p)(2)(B). D. Separate accounting while qualified status is determined. 1. While the plan administrator (or a court) is determining whether a domestic relations order is qualified, the plan is required to "separately account" for the amounts that would be paid to the alternate payee under the terms of the order during that period. Code section 414(p)(7). a. So a participant in pay status could be made to accept only one-half of the requested payments, if the order required payment to the alternate payee of the other one-half. b. In-service distributions (e.g., hardship distributions from a profit-sharing plan) probably should be held back in part, to the extent of the alternate payee's interest in those distributions under the terms of the order (e.g., 50%, if the order gave the alternate payee a right to one-half of the participant's account balance as of the date of the order). c. The plan's obligation to hold back and separately account under the Code literally does not begin until the plan receives an actual order (as opposed to a proposed order or mere notice of a pending divorce), so the plan administrator might be in breach of its duties to the participant if the participant is denied the right to make an in-service distribution in the desired amount or the participant is denied the right to self-direct the participant's whole account See Schoonmaker v. Employee Savings Plan of Amoco Corp., 987 F.2d 410 (7th Cir. 1993) (participant sued plan for failing to allow him to sell employer stock in his account; plan placed a hold on the account when it was informed of upcoming order by attorney for participant's ex-spouse). But the legislative history to TRA 1986 (which made some changes to the 18-month procedures) indicates a plan administrator "may delay payment of benefits for a reasonable period of time if the plan administrator receives notice that a domestic relations order is being sought." Conf. Rept. at II-858. The report goes on to illustrate a profit-sharing plan that is exempt from the spousal consent rules on lifetime distributions and says the plan administrator "may delay payment of benefits" in that case. This language did not find its way into the statute, however. And that legislative history states the plan is justified in continuing to hold back benefits even if the plan administrator determines the order is defective, if "the plan administrator has notice that the parties are attempting to rectify any deficiencies in the order." See Blue Book on the TRA 1984 technical corrections contained in TRA 1986 at 224. 2. Although the statute speaks of these amounts as the "segregated amounts," the former law requirement of an escrow account has been dropped. Accordingly, separate investment of these amounts is not needed. 3. If the order still has not been determined to be qualified within 18 months after the date on which the first payment to the alternate payee would have been required, the participant is entitled to be paid all of the amount being separately accounted for (and any interest thereon). Code section 414(p)(7)(C). a. The 18-month period does not appear to be a safe harbor, however. The fiduciary duties prescribed by ERISA upon plan administrators should require the plan administrator to make a decision sooner than 18 months if possible (as will usually be the case). b. If 18 months passes and the participant is paid the accumulated separate account balance, the plan is not responsible to the alternate payee to repay that amount even if the order is later determined to be qualified. Code section 414(p)(7)(D). But the alternate payee could go after the participant to recover the funds. 4. Is the alternate payee entitled to self-direct the amount that is separately accounted for? Or the amount that is assigned to the alternate payee under the order, even if not yet payable until the "earliest retirement age" (discussed later)? a. Seems like good policy, to avoid later complaints by the alternate payee about investments choices made by the participant. b. Because alternate payees are treated as "beneficiaries" for purposes of ERISA, a plan that allows self-direction for beneficiaries after the death of plan participants probably has to extend that privilege to the alternate payee. ERISA section 206(d)(3)(J). IV. IMPROVING THE PROCESSING OF INCOMING ORDERS A. Have a standard cover letter to accompany the QDRO procedures. (See the attached sample letters, in two versions: one for the alternate payee and one for the participant.) 1. Be sure the QDRO procedures are mailed promptly to the alternate payee and to the participant. Code section 414(p)(6)(A)(i). B. Consider drafting a memorandum to the alternate payee's attorney. C. Involve an attorney to represent the plan. Especially important to look for an attorney who is experienced in pension matters. Some litigation experience would be helpful. D. Consider providing a sample QDRO. E. Involve an actuary in the processing of an order affecting a defined benefit plan, in order to be sure the form of benefits specified in the order is not increasing the plan's actuarial cost. V. RESTRICTIONS ON TIMING OF PAYMENTS TO THE ALTERNATE PAYEE Literally, a plan is prohibited by the Code and ERISA from honoring an order that requires payment to an alternate payee before the participant is in pay status, because the order cannot require the plan to provide "any type or form of benefit, or any option, not otherwise provided under the plan." Code section 414(p)(3)(A); see also Conf. Rept. to TRA 1986 at II-858. A. Emphasis on "provided"; the statute does not use the word "available" but uses the word "provided," implying an actual payment of the participant's benefit. B. But the important exception: the Code and ERISA allow payments to begin to the alternate payee even if the participant has not yet separated from service, if (i) the participant has attained the plan's "earliest retirement age," (ii) the participant is treated as having retired on the date the order specifies the alternate payee's benefits are to begin, and (iii) the form specified in the order is a form that could be paid to the participant (except that the alternate payee is not entitled to demand payment in the form of a QJSA for the ex-spouse and his or her new spouse, if any). Code section 414(p)(4). Note the limitations to this exception: (i) the participant must have attained the plan's "earliest retirement age" already; and (ii) the forms of benefit available to the alternate payee are limited to those forms that would be payable under the plan to the participant if the participant had retired, including the time at which payments would commence to the participant upon his or her deemed retirement . C. What is the "earliest retirement age"? 1. If the participant is entitled to a distribution from the plan already (while still employed), he or she has attained the earliest retirement age. Code section 414(p)(4)(B)(i). Example: a profit-sharing plan allowing in-service withdrawals. The alternate payee can receive everything the participant could withdraw. Conf. Rept. to TRA 1986 at II-858. But what if withdrawals are available only if a participant has incurred a financial hardship? 2. If the participant is not yet entitled to a distribution from the plan (almost always the case; recall this exception applies only to payments before the participant has separated from service), he or she is consider to attain the earliest retirement age on the later of a. age 50, or b. the earliest date the plan would start paying benefits to the participant if the participant were to separate from service. Defined contribution plans generally allow distributions to separated participants immediately or shortly after the end of the Plan Year in which separation occurs, even before age 50, but "earliest retirement age" is the later of age 50 or the date at which payments to the separated participant would begin. So DC plans are justified in refusing to make payments to an alternate payee before the participant's 50th birthday, while the participant is still working. Indeed, it appears the DC plan must refuse to make payments to the alternate payee before the participant's 50th birthday if the participant is still working, unless the terms of the plan expressly allow for earlier payment to an alternate payee, whether by referring to such time as may be specified in a domestic relations order or by expressly providing some other special earliest commencement date for alternate payees. Without such language, payment to an alternate payee prior to the working participant's 50th birthday would not be authorized by the exception provided in the Code and ERISA, and could give rise to tax problems or liability to the participant on the part of the plan. Defined benefit plans generally do not start paying benefits to a separated participant before the participant's normal retirement age, which is usually past age 50. So DB plans generally can and must refuse to begin making payments to the alternate payee before the participant attains his or her normal retirement age. Again, the DB plan could contain terms expressly allowing for earlier payment to an alternate payee (see above). D. A qualified plan by its terms can allow earlier payments to an alternate payee. "A plan may provide for payment to an alternate payee prior to the earliest retirement age as defined under the conference agreement." Conf. Rept. to TRA 1986 at II-858. 1. But a governmental section 457 plan cannot. In PLR 9145010 (July 31, 1991), the IRS said a section 457 plan would lose its special tax treatment if the plan complied with a state court order to pay the alternate payee's benefit before the participant was in pay status. IRS reasoned that section 457 plans can allow payments only upon (i) separation from service, (ii) age 70-1/2, or (iii) an unforeseeable emergency. A divorce is not an unforeseeable emergency, said IRS. 2. Some governmental plans are tax-qualified under section 401 rather than section 457. Such plans are permitted to comply with QDROs just as are section 401 plans sponsored by private employers. See Code section 414(p)(11) (added by OBRA 1989). Presumably such plans could allow for earlier payments to alternate payees per the language of the TRA 1986 legislative history. The consent rules of Code section 411(a)(11) (regarding participants who have not yet attained the plan's normal retirement age or age 62, if later) do not apply to an alternate payee, unless the QDRO so provides. Treas. Reg. section 1.411(a)-11(b)(6). Hence a plan could "cash out" an alternate payee once the alternate payee's right to receive a particular amount has been established by the QDRO, unless the order requires the plan to obtain the alternate payee's consent before a distribution is made. VI. POSSIBLE ISSUANCE OF REGULATIONS BY DOL The Pension and Welfare Benefits Administration (PWBA) of the Department of Labor has asked for information to assess the need for a regulation clarifying the QDRO provisions of ERISA. The Request for Information was issued on October 21, 1993; information was requested by December 20, 1993. VII. ALTERNATE PAYEES AND DISCLOSURE REQUIREMENTS Alternate payees are treated as "beneficiaries" under ERISA, and hence have all the rights that a participant or beneficiary would have, as regards Summary Plan Descriptions and Summary Annual Reports. ERISA section 206(d)(3)(J), 104(b). An SPD should be supplied no later than 90 days after the alternate payee first receives benefits. See Labor Reg. section 2520.104b-2(a)(1) (beneficiary receiving benefits under a pension plan). The alternate payee would be entitled to updated SPDs and to a Summary of Material Modifications, if the plan is amended after the date of the QDRO. VIII. ALTERNATE PAYEES AND INCOME TAXES A. If the alternate payee is the spouse or ex-spouse of the participant, the alternate payee is responsible for payment of income taxes. Code section 402(e)(1)(A) (as amended by UCA 1992). But a payment to any other alternate payee (e.g., a child) is taxable to the participant. Ibid. This generally corresponds to the tax treatment of alimony (deductible) and child support (non-deductible). B. Basis in the plan is shared by the alternate payee and the participant, but only if the alternate payee is the spouse or ex-spouse. Code section 72(m)(10). If the alternate payee is a child, for example, the participant pays the income tax, and any return of basis is calculated without regard to the fact that the distribution is part of a QDRO. C. An alternate payee who is the spouse or ex-spouse has rollover privileges, whether into another qualified plan or an IRA. Code section 402(e)(1)(B) (as amended by UCA 1992). 1. Hence the spouse or ex-spouse must be given the right to have a direct rollover of the payments from the plan into an IRA or another qualified plan. Without a direct rollover, the taxable portion of the payments will be subject to mandatory 20% income tax withholding under the rules of UCA 1992. See Code section 3405(c) (as amended by UCA 1992), referring to "eligible rollover distributions" to which the 20% tax applies; see also Code section 402(e)(1)(B) including payments to spouse or ex-spouses as eligible rollover distributions. 2. And the spouse or ex-spouse will need to be given the Special Tax Notice Regarding Plan Payments (see the sample published by the IRS in Notice 92-48), regarding the right to roll over the distribution and the obligation of the plan to withhold 20% in the event no direct rollover occurs. Code section 402(f) (as amended by UCA 1992). 3. It appears a spouse or ex-spouse alternate payee can accept a distribution even if 30 days have not yet elapsed since he or she was given the Special Tax Notice Regarding Plan Payments, if a waiver of that right (i.e., the right to take up to 30 days to decide whether to have a direct rollover made on his or her behalf) is knowingly waived. IRS allows a waiver of the 30-day waiting period otherwise required by Temp. Treas. Reg. section 1.402(c)-2T, Q&A 12 if (i) the participant is given an opportunity to wait 30 days to make up his or her mind, if he or she wants to, and (ii) the plan administrator provides information to the participant "clearly indicating" that the participant has a right to this period for making the decision. Notice 93-36, IRB 1993-18 (May 3, 1993). That Notice relaxes the usual 30-day requirement as to Code section 411(a)(11) (requiring consent before payment prior to the later of normal retirement age or age 62 if later), but not the usual 30-day survivor annuity requirements of Code section 417. But neither 411(a)(11) nor 417 applies to the alternate payee. So the relief of Notice 93-36 seems to allow plans to pay alternate payees immediately upon receipt of a waiver of the 30-day period, even if the plan is a defined benefit or money purchase plan. D. Payments from the plan to the alternate payee per the QDRO will be exempt from the usual 10% early distribution tax on pre-59-1/2 withdrawals. Code section 72(t)(2)(C). Caution: the exemption is lost if the alternate payee rolls over a distribution into his or her IRA and then takes withdrawals from the IRA before 59-1/2. Those withdrawals would not be made pursuant to a QDRO. E. Grandfather election not assignable via QDRO. In PLR 9138004 (Oct. 18, 1990), the IRS ruled that a taxpayer who had elected the grandfather rule under the 15% excise tax provisions of Code section 4980A could not use a QDRO to transfer to his ex-wife the benefit of that election. She will be subject to the 15% excise tax on any excess retirement distributions caused by her receipt of the QDRO during life without any recovery of benefits under the grandfather rule, because she had not made the grandfather election. F. Withholding rules depend upon identity of the alternate payee. If the payments are taxable to the participant because the alternate payee is not the spouse or ex-spouse (i.e., the alternate payee is a child or other dependent), the plan is to withhold as if the participant were the payee. IRS Notice 89-25, Q&A 3 (describing the optional withholding rules that applied prior to UCA 1992). 1. Presumably it is the participant who decides whether to have the payment to the alternate payee made in cash (subject to 20% withholding) or in the form of a direct rollover, unless the order specifies the form of the payment (which is likely). 2. Notice 89-25 makes it clear that a non-spouse alternate payee cannot roll over a distribution from the plan. See also Code section 402(e)(1)(B) (limiting rollovers to alternate payees who are spouses or ex-spouses). But the participant can avoid income taxes on the distribution to the non-spouse alternate payee if the participant makes a contribution to an IRA or other eligible retirement plan within 60 days after the payment. Notice 89-25, Q&A 4. END