Involve an employee benefits attorney early, so the settlement agreement matches what the plan can actually do
In Illinois divorces and across the country, a growing number of the marital settlement agreements (MSAs) reaching our office assign a specific amount of the Roth funds in a 401(k), often to offset a house buyout or other after-tax asset. On paper it looks like a clean trade: after-tax dollars for after-tax dollars. The trouble is that many 401(k) plans cannot carry it out. When the QDRO reaches the plan administrator, the plan divides the account its own way, and the parties discover after judgment that the deal they signed is not the deal they got.
Almost every one of these problems could have been avoided by involving an employee benefits attorney before the agreement was finalized, so that the settlement agreement says what the plan can actually do.
Why this is coming up more often
Not long ago, most 401(k) balances were entirely pre-tax. Today, most plans offer a Roth contribution option, and recent legislation has accelerated the trend. SECURE 2.0 permits employers to make matching and nonelective contributions as Roth, and it requires catch-up contributions by higher-earning participants to be made on a Roth basis. As a result, it is now common to see a single 401(k) statement showing pre-tax deferrals, employer contributions, Roth deferrals, and sometimes rollover or after-tax money, all in one account.
Can a QDRO assign only the Roth portion of a 401(k)?
Inside the plan, each of those money types is tracked as a separate “source.” What the alternate payee receives from each source is governed by the plan’s written QDRO procedures, not by the settlement agreement. Plans generally fall into one of three groups:
- Pro rata only. The award, whether stated as a dollar amount or a percentage, is taken proportionally from every source in the account. This is the most common approach, particularly at large recordkeepers.
- Source selection permitted. The order may direct which sources the award comes from, including Roth only.
- Limited selection. The plan allows some designation but restricts it, for example by requiring Roth and pre-tax money to be treated together.
A QDRO cannot require a plan to provide any type or form of benefit the plan does not otherwise offer (ERISA § 206(d)(3)(D)). If the plan only allocates pro rata, an order directing a Roth-only assignment will be rejected, or the award will simply be taken pro rata.
Roth vs. pre-tax 401(k) money in divorce: why the tax difference matters
Pre-tax 401(k) money is taxed as ordinary income when it is distributed, and money assigned under a QDRO is taxed to the alternate payee who receives it. Qualified Roth distributions, by contrast, come out tax-free. The alternate payee’s Roth share also has to stay in a Roth vehicle, rolled to a Roth IRA or a Roth account in another plan, to keep that treatment. So when the parties bargain for $100,000 of Roth money and the plan delivers a blend, the alternate payee receives less after-tax value than the settlement intended, and the participant keeps Roth dollars he or she expected to give up.
| A common scenario
The settlement agreement awards Wife “$100,000 of the Roth funds” in Husband’s 401(k) to offset Husband keeping the equity in the marital home. The plan, however, only divides accounts pro rata, so most of what Wife actually receives is pre-tax money she will pay income tax on when she withdraws it. Wife ends up with meaningfully less after-tax value than she bargained for, and Husband keeps Roth money he expected to give away. Neither party intended that result. |
The cost of finding out after the divorce judgment
Too often, the retirement-plan side of a case is first addressed after the judgment has been entered, and that is when this issue comes to light: when the QDRO is drafted or submitted for pre-approval. At that point the parties must decide how to account for the different tax treatment of the pre-tax and Roth portions: what tax rate to assume, which party absorbs the difference, and how it gets paid. That requires analysis and calculations at additional cost, and if the parties cannot agree, it can mean post-decree motion practice and a delayed QDRO.
Involve an employee benefits attorney before the MSA is signed
Whether a Roth-only assignment is possible depends entirely on the specific plan’s QDRO procedures, and those vary widely. When we are involved before the settlement agreement is signed, we:
- Review account statements that break out the pre-tax, Roth, and other sources, not just a total balance;
- Confirm with the plan how it will allocate the alternate payee’s award; and
- Work with counsel on settlement agreement language so the parties’ intended result holds up regardless of how the plan divides the account.
The goal is simple: a settlement agreement that matches what the plan can actually do. Language that works for one plan can fail for another. A review while the agreement is still being negotiated costs far less than unwinding the problem after judgment, and it lets the QDRO be prepared and approved without a post-decree dispute.
Call us early: retirement asset division done right
If your settlement involves a 401(k) with Roth money, especially where the retirement account is being used to offset a house, maintenance buyout, or other after-tax asset, please bring us in while the marital settlement agreement is still being negotiated, not after it has been entered. Anne Prenner Schmidt, Esq., J.D., LL.M. (Employee Benefits), brings experience from the U.S. Department of Labor’s Employee Benefits Security Administration and an Am Law 100 firm, and our office approaches retirement assets as an integral part of the settlement, not an afterthought. Based in Highland Park, Illinois, we work with family law attorneys, mediators, collaborative professionals, and divorcing spouses throughout Illinois and consult with attorneys nationwide on QDROs, QILDROs, and other retirement asset division orders. We will:
- Review the plan’s QDRO procedures and confirm how the account will be divided;
- Identify whether the proposed division will deliver the after-tax value the parties intend; and
- Work with you on settlement agreement language that carries out the parties’ intent and reduces post-decree issues.
The earlier we are involved, the more likely the settlement agreement matches what can actually be done, and the fewer surprises there are for you and your clients.
To schedule a consultation, call 847-926-7679.
This article is for general information only and is not legal or tax advice. Tax consequences depend on individual circumstances; parties should consult a tax professional about their specific situation.