Divorce and the nonqualified deferred compensation plan (NQDC) can be an issue that is challenging to navigate. Obviously, the plan participant who is in the thick of it is dealing with demands on time, money, and emotions. But the plan sponsor can also have a role that calls for much more than nodding their heads sympathetically and saying, “That must be very difficult for you.”
Depending on who you ask, 2020 divorce rates either are spiking or are at a record low. Even if rates are in fact currently down, it wouldn’t be out of the realm of reason to think that a rebound uptick may be coming. Regardless, when it’s your divorce or that of one of your key executives, you need to understand how dissolving a marriage may impact a NQDC plan.
Starting with the QDRO
In settling the assets of the marriage, a family law court can issue a domestic relations order, known as a DRO. A DRO assigns some or all of a plan participant’s retirement benefit to a person other than the plan participant. While this person is almost always the employee’s spouse, under some circumstances, a child could become the alternate payee of the retirement benefits.
The DRO is the court order that starts the ball rolling. Once the retirement plan in question is reviewed to confirm that (among other things) it meets the requirements of ERISA, the Employee Retirement Income Security Act, the DRO is “qualified” and becomes a QDRO. According to “FAQs about Qualified Domestic Relation Orders,” published by the Department of Labor: “…Under Federal law, the administrator of the retirement plan that provides the benefits affected by an order is the individual (or entity) initially responsible for determining whether a domestic relations order is a QDRO.”
An employer or plan sponsor is required to honor a QDRO regarding a qualified plan (such as a 401(k) plan). The DOL’s FAQs also explain:
“A QDRO can assign rights to retirement benefits under more than one retirement plan of the same or different employers as long as each plan and the assignment of benefit rights under each plan are clearly specified.
“…Although every QDRO must contain certain provisions, such as the names and addresses of the participant and alternate payee(s) and the name of the plan(s), the specific content of the rest of the QDRO will depend on the type of retirement plan, the nature of the participant’s retirement benefits, the purposes behind issuing the order, and the intent of the drafting parties.
Discrete Rules for Divorce and the Nonqualified Deferred Compensation Plan
In the same way a NQDC plan is exempt from most requirements of ERISA, requirements are also different regarding the QDRO and an NQDC plan compared to a qualified plan. Although a plan sponsor must comply with a QDRO regarding a qualified plan, in the case of most NQDC plans, the plan sponsor may actually be prohibited from complying with the court order.
Kelsey A. O’Gorman, business lawyer, Foley & Lardner LLP wrote in Non-Qualified Retirement Plans & Divorce: You May be Able to Honor DROs, But Should You? “…nonqualified retirement plans that are considered “top-hat plans” under ERISA … are not bound by ERISA’s QDRO provisions, but arguably they are also not subject to state law regarding the division of marital assets. As such, employers have discretion to decide whether to honor or not honor DROs that assign some or all of a participant’s nonqualified plan benefits to an ex-spouse.”
In her article, O’Gorman goes on to explain that not only do many plans fail to include specific “assignment” language, but they may also actually include an “anti-assignment clause”. Such a clause would prohibit the plan participant (or plan sponsor) from assigning benefits to the participant’s ex-spouse or soon-to-be ex, even if the plan participant would like to do so.
Note: in some divorces, the inability of the non-employee spouse to receive payment from the plan participant’s nonqualified retirement benefits can trigger a supplemental agreement between the divorcing parties. This agreement may define payments due to the spouse at the time the plan participant takes distributions from the plan, such as at retirement.
Taxes and Accelerated Compensation Benefits Resulting from a QDRO
When deferred compensation benefits are accelerated because of the QDRO, taxes obviously become the big question. As soon as possible is the best time to consult a CPA and a knowledgeable executive benefits advisor. The next steps taken determine who pays the taxes, who bears the potential loss, how much these amounts will be, and whether there are options for either party to further defer taxes.
Once the best possible decisions are made given the circumstances, the plan sponsor must then understand how much federal income tax at the supplemental withholding rate to withhold or report to the IRS. FICA and FUTA employment taxes typically also come into play. Neither the plan participant nor the plan sponsor should proceed through this dense forest without guidance.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.
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