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Aftertax Contributions Can Save NUA

When plan assets contain employer securities, Qualified Domestic Relations Orders can be particularly problematic.

Helen Modly, 11/19/2009

Divorce is messy. Even once the settlement agreement has been reached, signed and filed with the court, our client still faces one remaining hurdle; the dreaded Qualified Domestic Relations Order (QDRO). When plan assets contain employer securities, QDROs can be particularly problematic.

Why a QDRO is Needed
A QDRO is required to transfer balances in retirement plans subject to ERISA from the plan participant to his ex-spouse. These legal documents are drafted by attorneys to describe how and when the division of plan assets is to take place. It is filed with the administrator of the retirement plan, usually the employer, who must accept it as being valid and conforming with the plan's rules. Then the administrator divides the ex-spouse/plan participant's account as directed by the QDRO and establishes a new account in the plan registered to the receiving spouse as an alternate payee.

What Does a QDRO Do?
In most cases, ex-spouses are entitled to all the investment or distribution options that would have been available to the plan participant. However, in many cases, these options are only available if actually spelled out in the QDRO. Many larger plans have sample QDRO language available for attorneys to use as a guide to drafting a valid document for that plan. In some cases, this sample language is more restrictive to the receiving spouse than the law allows, but the language used in the QDRO will prevail, if it is accepted. For example, it is not uncommon for larger employers to eliminate the ability for an alternate payee to receive an in-kind distribution of employer stock from the plan, unless specifically provided for by the QDRO.

QDRO's are a complex set of instructions. They tell the plan administrator how to divide the account such as each individual investment, pro-rata, or all the employer stock to one spouse and the balance of the assets to the other. QDROs have to address what happens to gains and losses in the investments from the date of agreement to the date of division, as well as establishing the actual date of valuation/division. They also have to address how to handle any outstanding participant loans.

The plan administrator is responsible for interpreting and effecting the division of plan assets per the QDRO. They can impose various conditions such as requiring that all plan assets must be distributed/rolled over within 60 days of creating the alternate payee account. To see how this can all coalesce into a perfect storm, let me tell you a story.

Our Client
She came to see us with a signed and filed separation agreement. Her attorney had already prepared a draft of the QDRO, and she wanted to discuss what to do with the retirement assets once they became hers. Her first inclination was to leave them with the plan since she didn't have much investment experience. Then she mentioned how she would need to use some of them to pay her attorney's fees and to replace the furniture her husband took as part of their settlement.

We looked over her QDRO and it clearly spelled out that she was to maintain all the investment and distributions options her husband had as well as keeping the same cost basis for all employer securities to be transferred. It did mention an outstanding participant loan, but she assured us that her husband had repaid the loan before the settlement agreement was signed. The date of valuation was stated as Dec. 1, 2008, and she was to receive the entire balance of his account as of that date, subject to any gains or losses. The QDRO was filed and we began drafting an investment policy for her.

Now the rub.

This client is only 52, has need for cash now, and may choose to supplement her salary from these assets until she retires. She has no savings outside her employer's retirement plan so having access to some of these assets over the next several years is very important.

Her plan account is worth $600,000 with almost $300,000 of that being the fair market value of employer stock. The employer stock is currently worth $75/share and about half of the shares were deposited into the plan with share prices of $10 to $15/share over the years. The balance was invested in a variety of mutual funds.

The valuation date in the QDRO was just a few days before the husband actually repaid the loan, so the plan administrator transferred all but the amount of the loan to her alternate payee account. She was also notified that per plan rules, the entire balance must be distributed within 60 days of the date of division (Oct. 22, 2009), OR the plan would cut her a check for the entire balance, less 20% withholding. The plan required a new QDRO to process the remaining plan funds which would not occur until sometime in 2010.

Under normal NUA rules, her distribution would have to qualify as a lump-sum in order to defer the tax on the NUA portion (fair market value less original cost basis) upon distribution. Without qualifying as a lump sum, the full fair market value of any stock distributed as a taxable distribution would be immediately taxable at ordinary income rates. A distribution in late December and another in January, regardless as to why, won't qualify.

This timing problem created by the faulty QDRO threatened to force her hand into taking a taxable distribution for the cash she needed, although no 10% premature penalty applies because this distribution is incident to a divorce. The remainder of the plan would have to be distributed/rolled into an IRA to avoid current taxation. She would lose the ability to distribute the employer stock at the low basis value and defer capital gains taxes on the NUA until sale.

Her Ace in the Hole: Aftertax Contributions in the Account
According to the plan statement she received after the alternate payee account was established, it was clear that $55,000 of the account's value represented aftertax contributions. Those contributions will be distributed directly to her without any tax liability.

But it gets even better. Regardless of whether her distribution qualifies as a lump sum, she can still distribute employer stock using the lower original cost basis value up to the $55,000 after-tax contribution limit without incurring any current tax liability. The cost basis of the stock is covered by the aftertax contributions, the difference between fair market value and the cost basis is tax deferred as NUA until the stock is sold. Upon sale, the NUA will be taxed as long-term capital gains. Any gains or losses since the date of distribution will follow the normal tax rules for short/long term gains or losses.

In her case, this means she can distribute up to 4230 shares of stock ($55,000 divided by $13/share tax basis) and no cash, or $55,000 of cash and no stock, or anything in between. I'd rather see her maintain the full flexibility that the lump sum distribution status would provide her, but this outcome is certainly better that what would happen with no aftertax amounts in the account.

The employer will provide her with a 1099-R describing the total amount of the distribution, $600,000. It will show the after-tax portion of the distribution, $55,000 and the amount of NUA depending upon how much stock versus cash she elects to receive. This could have been a real disaster--I am glad that I'm not the attorney who wrote the QDRO, but the presence of aftertax contributions will probably save her day.

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