Valuing & Dividing 457, 401(k)s, ESOPs, and Profit Shaing Plans for Divorce

When considering 457 Deferred Compensation plans and others as marital assets in divorce, the attorney should be aware of a few issues relating to the distribution of funds. First and foremost, however, 457 Deferred Comp plans are the governments version of the private sector’s 401(k). It is a defined contribution plan wherein the value is the account balance on any given date, for purposes of equitable distribution in divorce. ESOPs (Employee Stock Ownership Plans) and Profit Sharing Plans are defined contribution plans as well, wherein these two types will tend to have less flexibility in terms of the timing of distributions to a non-participant (alternate payee) spouse in a QDRO.

Often times in a divorce situation two critically wrong assumptions are made. First, it is assumed that because the plan has an account balance, an immediate lump-sum distribution is a sure thing. This is not always true and and an assumption often made with 401(k), ESOPs, and Profit Sharing plans. If an immediate distribution could be made, “immediate” to the plan administrator may mean within the next year based on a plan’s particular cash out period, this since retirement plans have long-term time horizons. Therefore before you assign all of the marital debt to one of the parties n a divorce, in hopes they will receive an immediate lump-sum distribution to pay off those debts, you may want to think again or contact the plan and inquiry as to their distribution policy.

The second incorrect assumption is that if an alternate payee to a QDRO elects to receive their share directly from the plan there will be tax penalties. This is not true since QDRO distributions are exempt from tax penalties, pursuant to the Internal Revenue Code Section 72(t)(2)(c). As with 401(k)s in the private sector, the pan is required to withhold 20% for normal income taxes since the contributions going into the plan were typically never taxed, but this is not a tax penalty. The objective generally is to take before-tax income, prior to it being paid out, and allocate it to a retirement account. The 20% then is not a tax penaltiy but simply the normal income taxes that would, in all liklihood, be owed on the distribution. Again, the 20% is a mandatory withholding. It should be noted that any direct distribution from the plan will be taxed as ordinary income in the year the former (non-plan partiucipant) spouse receives it, however because the 20% is based on the average effective tax rate for middle income Americans, the 20% should be sufficient to cover the taxes owed. Of course for very large distributions, those with larger incomes, or even those spouses with low incomes, more or less than the 20% will be required at the end of the year.

In addition, if the non-participant spouse has to receive a set amount from the 457/401k plan, they need to ask for more than is required to account for the 20% withholding. In fact they have to ask for 25% more ($ needed x 1.25) mathematicaly. For example, if the spouse (alternate payee in the QDRO) needed $10,000, say to pay attorney fees, and given the plan’s 20% withholding, $12,500 would have to be requested. $12,500 less 20% equals $10,000, therefore you have to go up 25% to come back down 20%, and arrive at the same number. Although in the above example the spouse needed to $10,000 to pay attorney fees, it is worth pointing out that QDROs can only be used to pay alimony, child support or divided as a marital asset. A QDRO cannot be drafted to award attorney fees or be paid to anyone else other than an alternate payee, defined as a spouse, former spouse or a dependent. That is even though QDROs cannot be used to pay attorney fees directly, nor to an attorney, the funds would have to be paid to the former non-participant spouse and they in turn pay the attorney. Another example, simply put, if the alternate payee is awarded $20,000 from the other’s 401(k), aside from any equitable distribution of assets, say to pay off a certain debt, to receive cash-in-hand, $25,000 would have to requested from the plan to net $20,000. Of course since the distribution is taxed as ordinary income, the alternate payee’s other income may result in more or less of a tax liability at the end of the year.

There is also the issue of earnings and losses. Generally the only financial instruments that pay interest are bonds and savings accounts, which includes CDs etc. Retirement accounts are generally invested in marketable securities (mutual funds, company stocks, etc.) so the value will fluctuate everyday. The question then is should the alternate payee be awarded gains and losses on their share or not? The answer is (generally) if the plan is being divided because it is simply a marital asset then gains and losses would or could apply to the alternate payee’s share as well. If the alternate payee is being awarded a certain sum because the participant spouse receive another asset of fixed value, then gains and losses would not have to apply. This issue becomes critical in volatile markets. The alternate payee wants interest, or the participant would like the spouse to incur the same losses in the account as they did since the effective date of division.The ultimate distribution will almost always be different than what was originally awarded, when awarding a lat dollar amount.

An example is the wife is awarded $10,000 to be paid from the husband’s 401(k) or 457 plan because the husband is to receive the fishing boat worth $10,000. By the way, there are two good points here. First is the QDRO should state that the wife is to receive $12,500 (recall from above) to account for the 20% withholding. The retirement account is a before-tax asset while the fishing boat is an after-tax asset. Regardless of the effective date, the intent is for the wife to receive $10,000 and therefore gains and losses (market fluctuations) would not apply. Now if the plan cannot make a distribution for a year or more, then the court can adjust the amount for interest but the plan cannot, if and again, the plan account is made up of marketable securities. An alternative is for the court to request that the plan participant spouse place the awarded amount into the most conservative investment until the alternate payee spouse receives a distribution. Most defined contribution plans offer a money market account within the selection of funds.

Lastly, with regard to discovery and 457 deferred comp plans, 457 deferred compensation plans are often provided in addition to pension plan, one that pays out a monthly pension benefit based on years of service and average annual income. Often because only the 457 account statements are mailed out, the pension benefit is overlooked. Also the 457 deferred comp plans should not be confused with executive deferred comp plans which are typically “non-qualified” plans which do not accept QDROs or any other type of order. Executive deferred comp plans are provided to pay benefits that exceed 415 limits or to avoid regulation.

Tim Voit is a Financial Analyst and author of Retirement Plan Benefits & QDROs in Divorce, a CCH publication. Tim Voit is founder of Voit Econometrics Group, Inc. which provides the legal community with pension valuations, business valuations, economic analysis, and QDROs. As an analyst, as well as being retained in malpractice cases, Tim Voit and his firm have aided attorneys and law firms in the drafting of Qualified Domestic Relations Orders (QDRO’s) and other Orders relating to private, governmental, and Military plans. Questions, or general inquiries can be made by contacting Tim Voit at askvoit@vecon.com.

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