Tax Language in QDRO

[QDRO Group]

Issue 1:  Do you believe that a plan administrator MUST reject a DRO if it contains tax language that is inconsistent with tax law?  For example, a DRO provision that distributions to a spouse or former spouse AP shall be taxed to the Participant or, conversely, that distributions to a child or other dependent AP shall be taxed to the AP.  Although most would say both provisions are inconsistent with federal tax law, can the plan administrator approve a DRO that contains one of them, then ignore the DRO tax provision and report/withhold based on applicable tax law?  If your answer is no, would it change your mind if the plan's QDRO procedures provide (1) the plan administrator will not reject a DRO based on any tax language in it, but (2) the plan administrator will report/withhold taxes as required by law, regardless of any inconsistent provisions in the DRO?

Issue 2:  Although it is clear that a Participant is taxed on distributions to a child or other dependent AP, there is no consensus on tax withholding from such payments.  Some TPA's do not withhold taxes from such distributions even without a withholding waiver on Form W-4P.  Some TPA's do withhold in this situation unless the Participant waives withholding on Form W-4P.  Earlier threads on this forum also don't produce agreement on this.  If you believe tax withholding is appropriate (absent a waiver), and if you received a DRO that directed the plan administrator not to withhold taxes from the distribution, would you (1) reject the DRO as inconsistent with tax law, (2) approve the DRO, but still withhold because the DRO is not an effective waiver, or (3) approve the DRO and not withhold taxes, treating the DRO as an effective waiver?  Does your answer change if the DRO also contained a provision, in the event the plan administrator requires a withholding waiver, that orders the Participant to fill out and return the appropriate tax waiver to the plan administrator?

[jpod]

Only commenting on Issue 1.  My advice would be to have counsel write a friendly letter to the Judge and the parties' lawyers explaining the error of their ways and explain that penalty risks to the plan administrator if it complied with that aspect of the order in fulfilling its tax reporting/withholding obligations.  If the court was local I would also ask for a hearing.  Then I would wait awhile and hope for the best.  If after waiting awhile there is no satisfactory resolution I would advise the plan administrator to approve the DRO but ignore the provision regarding taxes and comply with the tax law.  Having created that record would serve the plan administrator well if the AP's counsel raises heck and tries to drag you into court for contempt or what not.    

[My 2 cents]

My question is whether any plan administrators or third party administrators would pay any attention to any elements of a DRO purporting to modify standard taxation of the payouts?  What kind of an attorney could be so [trying to think of a suitable word other than incompetent] as to try to draft anything into a DRO so directly contrary to the law? 

Ditto for any judges writing violations of the tax codes into their orders.

I am not a lawyer or a tax expert, but I seem to recall having heard that distributions to an AP under a QDRO are taxable to the AP and not to the participant.  Clearly (if that is so), any provision trying to pass the taxability from the AP to the participant is unenforceable under all circumstances so may be safely ignored by all.  Report the distribution as usual, pretend that the offending provision is not there, and don't think twice.

I have no reason to believe that plan administrators have any responsibility for concerning themselves with the tax treatment of distributions (other than to report them properly).  Paying the directed benefits to the proper people and putting it on a 1099-R based on normal reporting rules should immunize the plan administrator against any possible imposition of contempt of court. 

[ESOP Guy]

I am just trying to make sure I understand the question.  In #1 is the DRO trying to merely adjust the payments to reflect the taxes? 

Example of what I mean:

Let's say the DRO says to split a $10k account 50/50.  It has a provision that says the participant is to "pay" the taxes for the AP.  It is determined the AP will owe $1K on her part of the $5k payment is here payment supposed to be grossed up to $6k?  I am ignoring the slightly more complex math that accounts for the fact the extra $1k is taxable so it should be something a little over $1k but you get my point. 

Is it possible they are trying to do what I described and wrote it poorly? 

I am guessing as I can see someone trying to do what I described but I am having a harder time thinking even divorce lawyers would actually think they get to just decide who owes a tax without reference to tax law. 

[shERPA]

I had this come up years and years ago.  I don't recall the specifics now but I told them the QDRO could not define the tax treatment.  They took that out, I don't remember if they changed the AP amount to adjust for it. 

[QDRO Group]

My 2 Cents:  Many domestic relations attorneys attempt to draft their own QDROs when they should have an expert do that.  Their lack of understanding of pensions reveals itself in numerous ways, including the misapplication of tax law.  We don't see this type of mistake on a daily basis, but we do see it enough that we are trying to develop a system of dealing with them without having to reject them.

ESOP Guy:  I don't believe they are trying to gross-up the AP, although that would put them in the same or a similar position as what they are telling us to do.

[My 2 cents]

Grossing up the amount payable to the AP ought to be acceptable - there's nothing out there prohibiting, for example, awarding 60% to the AP and 40% to the participant.  That has the advantage of not trying (improperly) to dictate who pays what for taxes.

[MoJo]

17 hours ago, My 2 cents said:

My question is whether any plan administrators or third party administrators would pay any attention to any elements of a DRO purporting to modify standard taxation of the payouts?  What kind of an attorney could be so [trying to think of a suitable word other than incompetent] as to try to draft anything into a DRO so directly contrary to the law? 

Ditto for any judges writing violations of the tax codes into their orders.

Well, to answer you question as to whether a PA or TPA would pay any attention to such a DRO is that IT IS AN ORDER OF THE COURT, and once accepted by the PA as a valid "Q"DRO, the plan (and the PA) becomes bound to the order, subject to the contempt powers of the Court issuing it.

The time to object to the invalidity of the order is BEFORE it is accepted as a QDRO.

I do agree with your subsequent post that "grossing up" the distribution to account for the tax consequences is a legitimate way to accomplish the goal - but that must be clearly spelled out in the order.

[My 2 cents]

5 minutes ago, MoJo said:

Well, to answer you question as to whether a PA or TPA would pay any attention to such a DRO is that IT IS AN ORDER OF THE COURT, and once accepted by the PA as a valid "Q"DRO, the plan (and the PA) becomes bound to the order, subject to the contempt powers of the Court issuing it.

The time to object to the invalidity of the order is BEFORE it is accepted as a QDRO.

I do agree with your subsequent post that "grossing up" the distribution to account for the tax consequences is a legitimate way to accomplish the goal - but that must be clearly spelled out in the order.

OK, to be on the safe side it should be rejected on the basis of the court lacking the authority to specify, in the order, the tax treatment of the distributions.  How's that? A guarantee that one will not face the possibility of contempt of court?

[MoJo]

39 minutes ago, My 2 cents said:

OK, to be on the safe side it should be rejected on the basis of the court lacking the authority to specify, in the order, the tax treatment of the distributions.  How's that? A guarantee that one will not face the possibility of contempt of court?

I would simply reject any DRO that "requires" a PA or plan to do something it can't legally do.  That alone is sufficient grounds to deny the DRO.  So, we agree on the conclusion, not necessarily on the reason (and one should trad cautious when trying to explain to a Court what they have authority to do and not do - that tends to land people in jail for contempt as well).

[RatherBeGolfing]

19 hours ago, QDRO Group said:

If your answer is no, would it change your mind if the plan's QDRO procedures provide (1) the plan administrator will not reject a DRO based on any tax language in it, but (2) the plan administrator will report/withhold taxes as required by law, regardless of any inconsistent provisions in the DRO?

Why would you have plan procedures that you approve something that you can't legally do and then ignore part of the order you just approved?  It is just a non-starter in my opinion.

 

[QDRO Group]

Is no one willing to take a stab at Issue 2 in the original post?

[jpod]

This is only a stab, because it's something which should be researched, and I'm not going to do that.  I'll answer the question by asking you questions:  What is the cause for doubt?  Why would there not be w/h?  Assuming w/h is required, if the order said DO NOT WITHHOLD TAXES, I think I could get comfortable treating that as the participant's election out of w/h and comply with the order, i.e., I can't imagine the IRS would impose penalties for failure to withhold in that situation.    

[My 2 cents]

What harm can withholding do?  Taxes will be due.  If the withholding is too much, you get it back as a refund.  If insufficient, then the more that was withheld, the less must be raised to pay the actual taxes when due.  Why do people think of withholding as though it represented a tax liability?  Thanks to the issuance of 1099-Rs, not filing is not an available option (unless it can be shown that the withholding was, at a minimum, sufficient to pay all taxes due and there is insufficient impetus to file for whatever would be refundable).

[jpod]

Ugh.  Because the parties and the judge want the AP to get the gross amount, not an amount net of withholding.

[MoJo]

4 minutes ago, jpod said:

Ugh.  Because the parties and the judge want the AP to get the gross amount, not an amount net of withholding.

Then draft the DRO to account for the taxes that could be withheld/are due....  One doesn't need to be "creative" to accomplish this.

Simple is ALWAYS better....

[My 2 cents]

5 minutes ago, jpod said:

Ugh.  Because the parties and the judge want the AP to get the gross amount, not an amount net of withholding.

May be true, but then, when it is reported to the IRS on Form 1099-R, the AP WILL HAVE TO PAY THE TAXES!!!  If there is nothing withheld, then it will be all that much more burdensome for the AP to come up with the difference in cash.  Not withholding taxes does nothing to ease the recipient's tax burden - just the opposite.  And (I believe) the tax laws say that the AP owes the taxes on payments made to the AP under a QDRO.  Neither the parties nor the judge can change that.

[StaceyHelton]

14 minutes ago, My 2 cents said:

May be true, but then, when it is reported to the IRS on Form 1099-R, the AP WILL HAVE TO PAY THE TAXES!!!  If there is nothing withheld, then it will be all that much more burdensome for the AP to come up with the difference in cash.  Not withholding taxes does nothing to ease the recipient's tax burden - just the opposite.  And (I believe) the tax laws say that the AP owes the taxes on payments made to the AP under a QDRO.  Neither the parties nor the judge can change that.

Issue 2 was referring to a child support QDRO, where the AP is not responsible for the taxes, the Participant is.  

The majority of child support QDROs I have dealt with were for fixed amounts, and they were treated as deductions from the Participant's full amount, so the Participant would be taxed appropriately based on the gross amount.  If the taxes were high enough that benefit was lower then the fixed dollar amount, I think we adjusted the taxes to allow for the QDRO to be paid and sent a new W-4P to the participant.  Either that, or the system automatically deducted the QDRO before the taxes, I can't recall for certain.

[david rigby]

Yes, the AP receives the QDRO distribution and it is taxable.  But, it seems presumptuous to assume the AP will owe taxes.  The PA does not need to know, and should not care, about the AP's tax situation.  The PA should provide to the AP exactly what is (probably) provided to any other distributee: the Special Tax Notice and a W-4P.

[david rigby]

5 minutes ago, StaceyHelton said:

Issue 2 was referring to a child support QDRO, where the AP is not responsible for the taxes, the Participant is.  

The majority of child support QDROs I have dealt with were for fixed amounts, and they were treated as deductions from the Participant's full amount, so the Participant would be taxed appropriately based on the gross amount.  If the taxes were high enough that benefit was lower then the fixed dollar amount, I think we adjusted the taxes to allow for the QDRO to be paid and sent a new W-4P to the participant.  Either that, or the system automatically deducted the QDRO before the taxes, I can't recall for certain.

Aren't most child support QDRO payments made to someone other than the participant? 

[StaceyHelton]

Yes, generally to a state agency on behalf of the child.  But the way it was handled in the payment system where I worked was that it was a deduction from the participant's benefit; a check went to the state agency, if there was anything left it went to the participant but the participant was taxed on the full pre-QDRO amount.

We actually had one participant with a number of child support orders that didn't get any payments for many years, everything went to the agency; the participant did get a 1099-R every year though.

[QDRO Group]

5 hours ago, jpod said:

What is the cause for doubt?  Why would there not be w/h?    

The doubt is the lack of clarity in the withholding Code sections and related regulations, and possible inconsistency with the actual taxation of distributions to child AP's.  Code Section 402(a) provides that a qualified plan distribution is taxable to the "distributee."  Section 402(c)(1) provides that a spouse or former spouse AP shall be the "distributee" for this purpose, but does not address child AP's.  I don't know the definition for "distributee" that applies to this section, but it likely is the employee/participant, regardless of who receives the distribution, since an exception was needed to switch the "distributee" designation to a spouse AP who actually received the money.  As a result, with no such exception for child AP's, the default rule that the participant is the distributee would apply and he/she would be taxed.

The withholding rules under Section 3405, on the other hand, generally refer to "payee," and do not address child AP's.  I believe some read "payee" to mean the actual recipient (a term used in the regs) of the distribution, which would be different from the "distributee" who is taxable in this case.  If the participant/distributee is the "payee" for purposes of withholding, then it seems the Code requires withholding unless the payee waives it on Form W-4P.  In this event, can a state court order serve as the participant/payee's waiver, or can it only be used to force the participant/payee to complete the waiver?  Also, Form W-4P permits the payee to elect a greater amount of withholding, so what measures can be taken to prevent the payee from having more withheld than required by law?  I've been told that an old IRS Notice (89-25 I believe - can't find it on the internet) appears to indicate the IRS believes the participant is the payee, but there still seems to be uncertainty surrounding this issue.  If the child AP is the "payee" does he/she have to waive withholding, or is there no withholding by default because the regs provide there is no withholding if the distribution is not includible in the gross income of the payee/recipient?

I have both reviewed QDROs for plans and have prepared QDROs for DR attorneys, so I'm interested in both sides of this issue.

[QP_Guy]

Here's a response i rec'd from an attorney on this issue:

Pursuant to 26 U.S.C 402(a) , taxation for all distributions should be made to the distributee.  However, Section 402(e)(1)(A), states that the alternate payee would be treated as the distributee when it is a spouse or former spouse of the participant where payment is made under a qualified domestic relations order.  Therefore, Stahl v. Commissioner, 81 T.C.M 1087 (2001)  held that where the distribution is made to a non-spouse alternate payee taxation should be properly assessed to the plan participant.    The court stated that Petitioner can only escape the taxation on the distribution where it is made to the spouse or former spouse.  And any distributions from petitioner’s pension plan to the child, not his spouse or former spouse, petitioner should be treated as the distributee and subject to the taxation.    IRS Publication 575 page 4 also states “ A distribution that is paid to a child or other dependent under the QDRO is taxed to the plan participant.” 

 

I know you also had questions regarding the amount of taxes to withhold and I hope this will address your questions regarding withholding 10% v. 20%. 

 

Pursuant to 26 U.S.C 3045, federal income tax must be withheld from any distribution unless the individual elects to not have withholding.  Any distributions during the lifetime of the participant to a nonspouse alternate payee should not be included in the gross income of the payee but rather included in that gross income of the plan participant.  This type of distribution would be considered nonperiodic distribution under 3045(b)(1) and therefore, withholding should equal 10% of the distribution.    Additional based on 26 U.S.C § 72(t) states that the participant may be subject to an additional 10% in taxes (or “penalty”) when taking an early withdrawal from their retirement plan, however, this taxation will not apply to the withdrawal taken pursuant to the QDRO. 

[QDROphile]

A well-advised plan administrator or special QDRO fiduciary will require the order to speak about how the withholding will be administered, primarily whether or not the distribution will be net of withholding.  If the distribution is to be net of withholding, then the order should specify the applicable withholding percentage, both federal and state.  If these terms are not established in the order, the matter is open for controversy at the time of distribution.  This is a qualification matter because  if the terms do not specify (or allow the plan administrator to compute by formula) the amount the AP actually will receive, the amount awarded is ambiguous.  The plan administrator doe not want to be in the middle of resolving disagreement over the actual amount to put in the hands of the AP at the time of distribution.   The plan administrator controls the issue at the stage of qualification.

[jashendorf]

Well, it should address withholding, where necessary. But there are not really alternatives to be specified. The required withholding is dictated by the form (and amount) of the distribution. Beyond that, the payee may have an option, but that is the payee's option -- not the Court's option (unless the Court wants to order the payee to elect something, which it can certainly do and which is of no concern to the plan). 

There is another withholding-related issue, however, with the child-support QDRO. Since the AP is not the spouse, in addition to the distribution not being taxable to the AP, the AP is not considered the distributee for rollover purposes (under 402(e)(1)). That leaves the Participant as the distributee. Even though the check hasn't gone to the Participant, cash is fungible so why can't he deposit an equal amount to an IRA w/in 60 days as a rollover, and avoid tax on the QDRO distribution? In other words, why is it not an "eligible rollover distribution"? And if it is, why is it not subject to mandatory 20% withholding (which would answer part 2 of the OP's question)?

[QDROphile]

Paragraph #2:  the IRS says that the participant may not roll over the distribution, notwithstanding that it is taxable.  I cannot recall when and in what form the statement was made -- I think it was not within a release that may be formally relied upon by taxpayers, such as a revenue ruling or even a notice.  This is not an issue for the plan.  As you point out, this is something the participant would do with an IRA and out-of-plan money.

Paragraph #1:  Allowing the the participant to exercise the payee's options for withholding at the time of distribution is exactly what will make a mess for the plan administrator.  What would the administrator do when the participant elects withholding of 100%?   The alternate payee would surely complain.  The administrator can strong-arm the issue as a matter of qualification and should do so.

[SavingsRUS]

This is a really helpful thread!

Follow up question: We have a participant whose attorney submitted a QDRO that names the ex-spouse as the alternate payee, but then directs the plan to pay the assignment amount to a local governmental entity responsible for collecting child support payments that are in arrears and specifies that the participant is the distributee for tax withholding purposes. Further inquiry revealed the participant is behind on their child support payments and the parties agreed to the assignment under the plan in satisfaction of those payments. To be consistent with the tax withholding requirements and distributee treatment, shouldn't the QDRO specify the child as the alternate payee instead of the ex-spouse?

[Mike Preston]

No.  In the case of a child AP the taxes remain the obligation of the participant.

[SavingsRUS]

4 minutes ago, Mike Preston said:

No.  In the case of a child AP the taxes remain the obligation of the participant.

But that's the question. Right now the QDRO names the ex-spouse as the alternate payee. If the ex-spouse is named as the alternate payee then the ex-spouse is the distributee and the taxes are the obligation of the ex-spouse alternate payee. If the parties intended for the assignment to satisfy a child support obligation, then shouldn't the QDRO name the child as the alternate payee and not the ex-spouse?

[Mike Preston]

I don't think "satisfying a child support obligation" definitively points one way or the other.  It could be tax efficient to do it this way.

[QDROphile]

I approach your question from a different perspective. 

First, a digression. A child support agency can get an order to have child support payments made to the agency by the participant's plan.  There are several threads on the subject that discuss the law and its relationship to ERISA.  One of the consistent contributors on the subject  besides me (so you can search) was MBozek or Mike Bozek.  If collection of child support arrears is what is really going on, then it should be addressed directly by the proper procedure.  The distribution should be taxable to the participant.  Unfortunately, competence of agencies is uneven, so there is often a backdoor attempt through use of a QDRO.  And it is certainly possible to use a QDRO, but usually that is mucked up as well because the same incompetence of the agency spills over into pulling off a legitimate QDRO.  I think you are faced with such a situation.

Taking the plan's perspective, if the QDRO is styled as applicable to an alternate payee who is a spouse or former spouse of the participant, then the plan must distribute to the alternate payee and must not distribute to the alternate payee's lawyer (there are threads about that), or an agency, or any other designated payee.  That is the end of the story for the plan, and the plan issues the Form 1099 to the AP (former spouse), who pays the taxes or rolls over the distribution.

If the plan is styled as a QDRO with children of the participant as APs, then the plan can pay an agency representing the interests of the children, which is the same as paying some other legal representative of the minor(s).  How the plan is to be convinced that the agency is the proper representative is another question, but plans should be entitled to rely on representations of government bodies concerning the state law applicable to the body and its functions and actions.  If the distribution is to the agency as agent of the children APs, then the participant is the taxpayer.  My comments about the plan paying only the former spouse AP under a QDRO applicable to the former spouse is based on applicable federal law, so no state authority can direct or advise the plan to pay the agency, rather than the spouse AP, based on state law.