Pensions, Retirement Plans, Deferred Pay, and Social Security
When dividing assets, don’t forget about the retirement funds. More than half the value of assets transferred in divorces each year are retirement funds. Because retirement plans are complicated and not readily convertible to liquid assets that can be spent, they can be the last thing on your mind when you are getting divorced. But overlooking them could be a costly mistake.
Pension Plans
A pension plan may be either a defined contribution plan or a defined benefit plan.
A retirement plan where the employee’s annual contribution is specified is a defined contribution plan. Most companies have this type of retirement plan. A 401(k) plan is a defined contribution plan. The employee, the employer, or both may make contributions to the plan. Individual accounts are set up with the funds contributed plus the earnings on those funds. The account may be self-directed by the employee, and the investments are usually made in the stock market. Only this amount is guaranteed. Future benefits will fluctuate depending upon the investment’s increase or decrease in value. The value of the plan is easily available from your last account statement.
If contributions were made to the plan before the marriage, the plan is part marital and part nonmarital property. You must calculate and subtract the nonmarital portion, including gains, losses, interest, and dividends to the date of division. The part that is left is the marital portion, which can then be divided or traded for another asset.
In a defined benefit plan, the employer promises to pay certain benefits, based on a formula, to the employee upon retirement. The formula uses factors like salary history and employment duration. A determination is made each year about what amount of money the plan must have at a certain date in order to pay out those promises in the future. The investments are entirely up to the company. The plan statements will show how much money is in the plan on a given date, but that is not the value of the plan. The value has to be determined by an actuary using assumptions about retirement, life expectancy, appreciation of plan assets, and inflation rates. This is an expensive proposition and may cost you around $5,000.
If you want to trade defined benefit plan assets for another marital asset, then you will need to have the plan valued. If the plan was started before the marriage, it will be part marital and part nonmarital. The marital share is calculated as a fraction. The numerator is the number of months you have been married during your spouse’s participation in the plan. The denominator is the number of months your spouse participated in the plan to the date of retirement.
In lieu of valuing the plan, the court can order it divided “if, as, and when” received.” For example, the court could order the plan to pay one-half the marital share to the other spouse if, as, and when payments are made to the spouse that is the employee.
Note Retirement funds can be a major part of the marital property to be divided. You may need to engage an actuary to value the plan, who will value the marital portion of the plan based on the length of your participation until retirement and the length of your marriage.
A retirement plan may either be qualified or not qualified for favorable tax treatment. If your plan meets the requirements of the Employee Retirement Income Security Act (ERISA) and Section 401(a) of the Internal Revenue Code, it is said to be tax qualified. The requirements are that the plan does not discriminate in favor of highly paid individuals and that benefits are reasonably determinable. If the plan is tax qualified, you do not have to report contributions as income and you can defer taxes until the contributions are withdrawn, usually at retirement. The contributions can grow tax free until withdrawal. In the meantime, however, your employer can deduct contributions in the year they are made.
ERISA applies to 401(k) plans, Keogh plans, money-purchase pension plans, defined benefit plans, target benefit plans, and profit-sharing plans. It does not apply to government, military, or international organization retirement plans or individual retirement accounts (IRAs). It also does not apply to some private, nonqualified plans. All of these plans fall under other rules than those of ERISA.
Alienation
Alienationis a fancy word for selling, assigning, or transferring. ERISA and the Internal Revenue Code provide that you cannot transfer your pension plan benefits to another person. These are called the antialienation provisions. They are federal law. The purpose of these provisions is to make sure your benefits are there for your support during retirement.
So, in the past when a divorce court issued an order dividing a pension and assigning a portion to the spouse of a participant in a pension plan, it raised a question: If the plan complied with the state order, did this violate the federal antialienation provisions of ERISA and cause the plan to be disqualified and lose its tax advantages for all employees?
Congress to Rescue: The QDRO
Congress made a special divorce exception to the antialienation provisions by enacting the Retirement Equity Act (REA) of 1984. That act allows qualified pension plans to be divided by state divorce courts with a special order, without losing favorable tax status. The order is directed to the plan administrator.
The order transferring retirement benefits is known as a qualified domestic relations order (QDRO). Under the QDRO exception, a state court may transfer an employee’s retirement benefits to a spouse, former spouse, child, or other dependent. This transfer may be used to pay alimony, child support, or a marital property obligation. A pension plan does not have to comply with a state court ordering the division of pension benefits unless the order is a QDRO.
As mentioned, the QDRO is a “domestic relations order.” A domestic relations order is a judgment, decree, or order, including an order approving a property settlement that is made under a state’s domestic relations law regarding the child support, alimony, or property rights of an alternate payee.
The judge must actually issue the order. A property settlement agreement signed by the parties cannot by itself be a QDRO unless it is approved by an order of the court.
There is no requirement that the order be signed or approved by the parties, but many judges and lawyers will have the parties sign it anyway. You do not need to present the retirement plan to the court nor make the plan administrator or the plan a party to the divorce.
The employee is referred to in the QDRO as the participant. The spouse, former spouse, child, or dependent of the participant is called the alternate payee. The plan administrator is the person or entity so identified in the plan documents. You will find the name, address, and telephone number of the plan administrator in the plan’s summary plan description. The administrator is required to provide a summary plan description to each participant describing her rights and benefits under the plan.
A QDRO, which transfers retirement benefits from the participant to the alternate payee, must contain the following:
- the name and address of the participant
- the name and address of each alternate payee
- the name of the plan (note that some companies have several plans with similar names)
- the dollar amount or percentage of the benefit to be paid to the alternate payee, or a method of calculating the percentage
- the number of payments or time period to which the order applies
A QDRO must not contain the following:
- any benefit or option that is not provided by the plan
- a requirement for the plan to provide for increased benefits
- a requirement for the plan to pay benefits to an alternate payee that are required to be paid under a prior QDRO to another beneficiary
- a requirement for the plan to pay benefits to an alternate payee in the form of a qualified joint and survivor annuity for the lives of the alternate payee and his subsequent spouse
Usually, a QDRO is prepared as a separate order. That is not required, however, and it may be part of the divorce decree or part of a property settlement agreement as long as the agreement is approved by a court order.
A QDRO does not need to be issued only in a divorce. You can sue for alimony or child support without filing for divorce. Any domestic relations order that provides for support or marital property rights may be a QDRO.
A QDRO can be issued after a divorce, after the participant’s retirement, or even after the participant’s death. But it is a better practice to have it prepared and entered at the time of divorce. Once the QDRO is submitted to the court and signed by the judge, it is mailed to the plan administrator. The plan administrator then determines whether the order is qualified or not. For that reason, some plans provide drafting templates for QDROs and preapproval of QDROs before submitting them to the court. QDROs are also drafted with provisions that permit the court to modify them if required by the plan administrator. It is also possible to include a provision that the funds be paid from other assets if the QDRO is not approved.
Marital settlement agreements frequently provide that retirement funds will be divided but lack details on how that is to be accomplished. That leaves too much room for disputes when the QDRO is drafted later. Whose lawyer will draft the QDRO? Who will pay for it? It is better to include as much detail as possible in the agreement. The best practice is to draft it at the same time as the agreement and attach a copy.
Tip You need a QDRO to divide pension plans that are qualified for tax benefits under ERISA. Have it prepared and preapproved at the time you sign the settlement agreement or by the time of your divorce trial.
If your QDRO provides for payments from a defined benefit plan if, as, and when received, you need to know about the survivor benefit. A survivor benefit acts like a life insurance policy. It permits the alternate payee to continue to receive benefits after the death of the participant (typically about half the benefit received during the life of the participant). There is a cost for securing the survivor benefit, and it is subtracted from the pension payments each month. The QDRO must assign this benefit to the alternate payee or all payments will stop if the participant dies.
The questions most often raised in divorces about survivor benefits are threefold: Will the alternate participant receive a survivor benefit? If so, how much of the benefit will be assigned? And who will pay for the survivor benefit?
If the plan does not provide for a survivor benefit or the participant won’t agree to it, the alternate payee can buy a private life insurance policy on the participant’s life.
It is possible to assign part or all of the survivor benefit. It makes sense to assign the same percentage as the percentage of benefit that the alternate party receives while the participant is living. This will leave a partial survivor benefit for a new spouse and children if the participant remarries. But it is possible to assign more than this, up to 100 percent of the survivor benefit.
The survivor benefit is paid for by deduction from the monthly pension benefit. The deduction reduces the monthly benefit paid both to the participant and the alternate payee. However, because the survivor benefit is only for the alternate payee, the parties sometimes negotiate that the entire cost will only be deducted from the alternate payee’s benefit payments.
Note If you don’t buy a survivor benefit, payments will stop upon the death of the employee.
A deferred compensation plan is the most common nonqualified plan, although it is not the only type. Companies set up nonqualified plans to reward their most highly paid executives. The employee contributes a portion of her pay to the plan and does not pay taxes on those contributions until they are withdrawn from the account at retirement.
Some nonqualified plans are fully funded currently and can be divided in a divorce. Others are not funded currently but consist of a promise to pay benefits in the future, or may have provisions that do not allow for a division in a divorce. In that case, you can have an expert value the plan and trade it for other assets or establish an agreement and court order under which the employee will pay the former spouse a percentage of the benefit if, as, and when received.
Individual Retirement Accounts
Individual retirement accounts are less complicated. They do not fall under the antialienation rules of ERISA or the QDRO exception. You do not need a court order to divide an IRA. They may be divided by an agreement of the parties. Usually, the institution holding your IRA will require only a form or a letter in order to divide the account. The court may issue an order dividing an IRA, but it is not required.
The transfer is tax free to you if it is made under a divorce decree or separation agreement incident to a divorce. The transfer must be paid into an IRA owned by your spouse in order to be tax free to him.
Sometimes a spouse needs the money at the present time and doesn’t want to put it into an IRA. You would then have to pay income tax on the distribution. There is a 10 percent penalty if you withdraw funds from a qualified plan before age 59.5. This 10 percent penalty is waived for qualified plans if the distribution is pursuant to a QDRO but not for IRAs.
Note If you don’t transfer part of the IRA into another IRA, and you’re not yet 59.5-years-old, then you’ll need to pay a 10 percent penalty for the withdrawal in addition to any income taxes due.
Federal Government Retirement Plans
All employees of the federal government have a defined benefit retirement plan (either CSRS or FERS, described below) and a defined contribution plan (TSP). The plans are divided by a qualifying court order, which is similar to but not the same as a QDRO.
Civil Service Retirement System
Federal government employees who started their civil service prior to 1984 are covered by the Civil Service Retirement System (CSRS). Since this is a defined benefit plan, it will have to be valued by an actuary or divided on an if, as, and when received basis.
Employees who are in the CSRS may also contribute up to 5 percent of their earnings to a Thrift Savings Plan, or TSP. There are no employer contributions. The administrator for the TSP is the Federal Retirement Thrift Investment Board, 805 15th Street NW, Washington, DC, 20005-2207 (telephone: 202-942-1600).
Under the CSRS, employees do not make contributions to, or qualify for, social security as a result of their government employment. When one spouse is a federal employee with CSRS and the other spouse is entitled to social security, a divorce court can divide the CSRS but is prevented from dividing social security under federal law. Some states permit the judge to make adjustments in dividing assets to take into account the fact that you cannot divide social security.
Federal Employees Retirement System
Federal employees hired after January 1, 1984, are covered by the Federal Employee Retirement System, or FERS. It is a defined benefit plan. Under FERS, employees will receive a basic benefit at retirement equal to 1 percent of their average earnings for each of their top three years of service. They are also eligible for social security. The government will contribute 1 percent of the employee’s pay to her TSP and will also match the employee’s contributions to the TSP dollar for dollar for the first 3 percent and half of the next 2 percent taken out of her paycheck.
International organizations have their own retirement plans and operate under their own rules. The World Bank and the International Monetary Fund, for example, will not accept a state court order dividing a pension benefit unless it takes the form of an order to pay alimony.
Unlike in the case of civilian pensions, service members cannot borrow against or cash out early from a military pension. It is all or nothing. They cannot receive any benefit until they have served at least 20 years (or have acquired the necessary points through the Reserves or National Guard).
The Uniformed Services Former Spouse Protection Act (USFSPA) provides that state divorce courts can divide military pensions and enter an order awarding a portion of the military pension to a former spouse. You and your spouse can either agree on the division and have your attorney prepare the court order, or you can ask the judge to award you a portion of the pension if you cannot agree.
There are different ways to divide a military pension. The former spouse can receive a percentage or a specific dollar amount. You can also trade your share in a military pension for cash or other assets. In this case, you will need the pension to be valued by an expert.
The government agency in charge of paying military pensions is the Defense Finance and Accounting Service (DFAS). A former spouse may receive court-ordered pension payments directly from the DFAS if he meets the following requirements:
- The decree of divorce judgment and the order dividing the military pension are both final and unappealable;
- the service member is retired or in the process of retiring; and
- the service member has served at least ten years in the military and the parties were married for ten years during the member’s military service.
The DFAS cannot pay a former spouse more than 50 percent of a service member’s disposable net pay nor more than 65 percent in total if there is more than one court order. If you are entitled to more than that, or you don’t qualify for direct pay, you will have to collect it from another source such as a bank account or wages if the service member takes a civilian job after retirement from the military.
Disposable Retired Pay vs. Disability Pay
The benefit to the former spouse is typically a percentage of the service member’s disposable retired pay. This is the monthly benefit less the following items:
- The debts owed to the United States, such as advanced pay;
- the fines assessed against the service member, such as court martial penalties;
- the amounts waived by the service member to receive an enhanced civil service retirement benefit if she goes to work for the federal government;
- the amounts waived by the service member in exchange for the receipt of disability pay; and
- the costs of a survivor benefit plan.
If a service member is eligible for disability pay, he can elect to take disability pay instead of retirement pay on a dollar-for-dollar basis. This will reduce the former spouse’s share of the military pension. There is an incentive for doing this because disability pay is tax free while retirement pay is not. Disability pay is not divisible in a divorce.
Spousal benefits and survivor benefits are a valuable feature of social security for married people. When you reach 66, the eligible retirement age, you can claim half your spouse’s retirement benefit if it is higher than your own full benefit. You are also entitled to a benefit if your spouse dies.
Divorce courts won’t divide social security benefits. But most of the benefits for married couples are still available to you if you get divorced; provided you are single, were married to your ex for at least ten years, are at least 62-years-old, and are not already receiving a social security benefit higher than the divorced spouse’s benefit.
If your divorce has been final for at least two years, you can file for the divorced spouse’s retirement benefits even if your ex is not receiving benefits.
If you remarry, you lose these benefits and you will have to be married to your new spouse for one year before you can file for benefits based on her earning record.
One strategy for divorced spouses works like this: If your own benefit is less than half your ex’s benefit when you reach retirement age of 66, you can claim your divorced spouse’s benefit. Then, at age 70, if your own benefit has grown in excess of your divorced spouse’s benefit, you can switch to your own benefit.
Another strategy is switching back and forth between multiple ex’s benefits, selecting the highest benefit, as long as you have been married to each of them for at least ten years.
Note Social Security benefits are not divisible by the divorce court, but some states allow the judge discretion to take them into account in dividing other marital property.
Summary
When dividing marital property, retirement funds can be a valuable asset. Sometimes, retirement funds are part marital and part premarital property. Defined contribution plans can be readily valued by looking at the current account statement. Defined benefit plans require valuation by an actuary or division if, as, and when received. It takes a QDRO to divide plans covered under ERISA. Other plans are divided by different methods. The survivor benefit is a valuable part of a pension plan but must be paid for on an ongoing basis. Social security benefits are not divisible in a divorce court, but divorced spouses are entitled to certain benefits.
The next chapter will discuss how to divide a business in a divorce.