The American Retirement Association (ARA) was recently notified of a legal scheme in Texas – a community property state – that allows younger workers to raid up to 100% of their defined contribution (DC) plans (eg 401(k), 403). (b) or 457 plan) account balance without tax penalty for an early, in-service retirement plan distribution. The only catch is that the DC plan participant must be married.
How does it work?
In Texas—and possibly other community property states—married people can enter into a postnuptial agreement, whereby community property is reclassified as separate property. After such an agreement is reached, a married 401(k) participant must obtain a Qualified Domestic Relations Order (QDRO) to effectuate this property settlement. Usually, this involves hiring a lawyer. For example, a Texas lawyer charges $4,000 in legal, processing and court-filing fees to obtain a QDRO.
The QDRO assigns up to 100% of the DC plan account balance to the non-participating spouse as an alternate payee under the QDRO. A QDRO requires the plan administrator to establish an account to transfer the designated amount to the alternate payee’s account.
Generally, plans allow alternate recipients to take distributions even if the participant is not currently eligible for a distribution—and, in fact, the plan requires in certain cases. Therefore, once the QDRO is processed, the non-participating spouse is allowed to make a distribution. Voila!—the DC account is “unlocked.”
As with distributions to the participant, the alternate recipient will be allowed to take cash distributions and pay income taxes on the distribution or rollover certain amounts into a tax-deferred account such as an IRA. However, unlike a distribution to a participant, because the distribution is pursuant to a QDRO, the alternate payee is exempt from the additional 10% tax on early withdrawals under Internal Revenue Code (IRC) section 72
What are the effects?
If the retirement plan does not allow in-service withdrawals or the participant is not yet eligible for in-service withdrawals, such a transaction is an abusive practice that undermines the plan’s purpose of protecting American workers’ savings so they can enjoy an economically secure retirement. The sole purpose of engaging in these transactions is to gain immediate access to funds that would otherwise be inaccessible and to enable the parties to avoid the 10% additional income tax penalty.
The general counsel for a longshoremen’s benefit fund in Texas told us that in the past six months alone, the retirement plan received 14 QDROs for 14 different members, all following the same structure, drafted by the same attorney and signed by the same judge. Furthermore, there is no limit to the number of transactions a married participant can make during his career.
This situation creates a huge gap for married participants in community property states to prematurely access retirement funds, thereby jeopardizing a dignified and secure retirement.
Andrew Remo is the ARA Director of Federal and State Legislative Affairs.