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Divorce and the Retirement Plan Quagmire By Stephen J. Butler

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Most of the time, investing for retirement deals with matters that are optimistic and positive -- building and saving for the future, creating wealth to realize dreams and ambitions. Unfortunately, there is also a painful side. Some people find themselves involved in the trauma of divorce, a disputed will, or other family legal battles, during which 401(k) assets become just another football in the courtroom fracas.

Should you face a divorce or similar crisis, there are some important considerations that you should know in regard to retirement plan assets.

The complexity of these situations is illustrated by a dispute surrounding the estate of the late Charles Kuralt, the avuncular CBS-TV commentator who was well known for his travel reports, "On the Road." Kuralt allegedly wrote a letter late in life that gifted a ranch to a woman his wife had never heard of. Later, the question became whether or not the letter had the power to supersede earlier instructions in his will.

Had Kuralt been a resident of California, he would have been attempting to give away something of which half belonged to his wife. That would have been a definite "no-no" and would have been swiftly struck down. Instead, the transaction for Kuralt, who was a resident of a non-community property state, created a legal quagmire that had to be decided by a judge.

Your retirement plan money should not be shrouded with a big question mark about ownership during a contentious dispute such as that surrounding the Kuralt estate. In cases of divorce, a Qualified Domestic Relations Order (QDRO - pronounced "quadro") is the court-approved agreement that dictates how plan money will be distributed. Most plan administrators will not distribute money in a divorce until they receive this official court sanction.

The QDRO is important because it grants a spouse all the rights and tax protection that would have applied if he or she had been the retirement plan participant. Thanks to the magic of tax-deferred compounding, 401(k) funds can easily be the most valuable asset belonging to a household, so high economic stakes are riding on the QDRO.

Unfortunately, some people try to work through their break-up with one of those books with a title like "How to Save Money by Doing Your Own Divorce Without A Lawyer." They can easily miss the requirements of a QDRO. The result can be a devastating tax hit, with possible penalties for the spouse who winds up with the retirement money.

If you are a former spouse who has received a retirement plan distribution under a QDRO, you may rollover some or all of your distribution to your own IRA, or to your employer's retirement plan, on a tax-sheltered basis. More good news: if you spend some of the money, you get a special break on this expenditure. You will not owe the 10% penalty that would normally have applied had you taken an early withdrawal before age 59 and one half. This is true regardless of your age or your former spouse's age.

Once the rollover is complete, the assets become yours in every respect. There is no "hand out of the grave" opportunity for your former spouse to change his or her mind.

For women in a divorce, there's a red flag to look out for. It is customary for the wife to receive equity in a house as part of the property split, and for the husband to keep his pension plan assets. This may not be the best approach, from the woman's perspective.

Over time, residential property has only increased in value at a rate of 3% per year. Remember the early 1990's when home prices dropped? By comparison, the stock market has increased in value at a rate of around 10% per year over the decades - even with the periodic gut-wrenching declines such as the NASDAQ has suffered over the past year and a half.

If you are negotiating a split of assets, it may be wise to set aside any current real estate hysteria and insist on a mix of retirement plan and home equity for both parties. This would be true even if the home has to be sold or refinanced.

Both parties in a divorce need good counseling to arrive at what should be an equitable property settlement. A lot of emotion and angst will probably be expended on who gets the family heirlooms, the Porsche or the vacation cottage. Remember, though, that retirement plan assets can be more valuable than they appear, because of the tax-free build-up and the potential of providing a stream of income at an earlier age than normal retirement. Home equity, by comparison, may not be as useful or as profitable in the long run.

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