Colorado QDRO Avoids Tax Liability and Penalties

Summary:  Federal ERISA law allows you to divide retirement plans in a divorce or legal separation without having to pay income tax or the 10% early withdrawal penalty. Other QDRO uses, such as the collection of child support or maintenance, are also accomplished without having to pay income tax pursuant to the division of a retirement plan. Without a QRDO, the transfer is taxable to the transferor.

General Tax Rules for Withdrawal from a Retirement Plan

Whenever a plan Participant (such as an employee with a 401(k)) withdraws money from a retirement plan, income tax must be paid on the amount withdrawn. Sometimes a 10% early withdrawal penalty must also be paid. This includes the withdrawal and transfer to a spouse or former spouse.

If a plan Participant transfers money to a former spouse pursuant to a divorce, the plan Participant has to pay the income tax on the withdrawal, as well as the 10% early withdrawal penalty if it applies to the withdrawal.  The tax effect is the same as if the withdrawal was done without any divorce proceeding.

The same rules apply to the transfer of an IRA.

You don't want the additional financial burden of an unnecessary income tax at the time of the divorce.

The QDRO Income Tax Advantage

When a QDRO is used to divide retirement plan assets between former spouses pursuant to a divorce proceeding, the division is done tax-free.

The plan Participant (employee) pays no income tax.

The former spouse (Alternate Payee) who is receiving the retirement plan benefits will pay income tax at the time of the later withdrawal from the retirement plan.

An IRA can be divided pursuant to a divorce without the use of a QDRO, however you have to make sure that your letter of instruction to the IRA administrator clearly shows that the transfer is done pursuant to a Colorado divorce.  Otherwise, your IRA transfer could be taxable.

The QDRO Penalty-Avoidance Advantage

If done correctly, that former spouse (Alternate Payee) who receives the QDRO account can withdraw retirement benefits received through a QDRO without having to pay the 10% early withdrawal penalty. However, the 10% early withdrawal penalty can be a tax trap if the withdrawal is not done correctly. For example, if the former spouse rolls the separated retirement assets into an IRA and then withdraws the money from the IRA, that withdrawal is subject to the early withdrawal penalty laws. So - be careful about how you structure a withdrawal from a QDRO division of a retirement plan.