DIVORCE OBLIGATIONS COLLATERALIZED WITH QUALIFIED RETIREMENT PLAN AND QDRO
How often have you seemingly reached a divorce settlement in a high asset, low-liquidity case only to be stymied by lack of collateral or security for deferred payments? You might consider a sometimes overlooked source of collateral: a Qualified Domestic Relations Order.
Normally the creation of a security interest in a qualified plan will cause a constructive distribution of the portion pledged or even possible disqualification of the plan. But check out IRC Section 401(a)(13)(B) as well as Letter Rulings 9234014 and 200252093. These provide that the creation of a security interest or right to any benefit payable with respect to a domestic order that would normally be disallowed will not apply if the security interest is pursuant to a Qualified Domestic Relations Order.
Thus, the QDRO can secure the payer spouse’s obligations under the divorce agreement for deferred property settlement payments, alimony payments and child support payments (even professional fees).
An interesting question arises as to who pays the embedded income tax on the retirement plan. Generally, the recipient spouse is taxed on the distribution (although the 10% penalty for early withdrawal does not apply) but after-tax dollars are better than no dollars. This should be kept in mind when negotiating the terms of such an arrangement. The usual solution is to gross-up the amount being collateralized to include the anticipated income taxes. In addition, the payer spouse’s cost basis is allocated in part to the recipient. The payer spouse is not taxed on the distribution, unless the distribution is paid to a child or other person, not the spouse or former spouse.
When dividing marital assets, liquidity often is a problem. This can be especially true if the major non-retirement assets are a family business and/or a family home. The technique outlined here provides an opportunity to resolve this problem and move a case toward settlement.