The American Retirement Association (ARA) was recently informed of a legal scheme in Texas—a community property state—that allows younger workers to raid up to 100% of their defined contribution (DC) plan (such as a 401(k), 403(b) or 457 plan) account balance without incurring the 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 presumably in other community property states—married persons can enter into postnuptial agreements, whereby community property is recharacterized as separate property. After such an agreement is made, a married 401(k) participant must obtain a qualified domestic relations order (QDRO) to effect this property settlement. Generally, this would involve hiring a lawyer. For example, one lawyer in Texas charges $4,000 for the legal, processing, and court-filing fees to obtain the QDRO.
The QDRO assigns up to 100% of the DC plan account balance to the non-participant spouse as the alternate payee under the QDRO. The QDRO requires the plan administrator to establish an account for the alternate payee to transfer the designated amount into the alternate payee’s account.
Typically, plans permit alternate payees to take a distribution even if the participant is not currently eligible for a distribution—and, in fact, the plan is required to do so in certain instances. Therefore, once the QDRO is processed, the non-participant spouse is permitted to take a distribution. Voila! — the defined contribution account has been “unlocked.”
Similar to a distribution to the participant, the alternate payee will be allowed to take a cash distribution and pay the income tax on the distribution or rollover the designated amount into a tax-deferred account like an IRA. However, unlike a distribution to the participant, because this distribution is pursuant to a QDRO, the alternate payee is exempt from the Internal Revenue Code (IRC) Section 72(t) additional 10% tax on early withdrawals.
What’s the Impact?
If a retirement plan does not allow in-service withdrawals or the participant is not yet eligible for the in-service withdrawal, this type of transaction is an abusive work-around that undermines the purpose of the plan to protect the savings of American workers so that they may enjoy an economically secure retirement. The only purpose of engaging in this transaction is to gain immediate access to funds that would otherwise not be accessible and enable the parties to avoid the 10% additional income tax penalty.
The General Counsel of a longshoremen’s benefit fund in Texas told us that in the last six months alone the retirement plan has received 14 QDROs for 14 different members, all following the same structure, drafted by the same attorney, and signed by the same judge. Further, there is no limit to the number of transactions a married participant can make during her working career. This situation creates a huge loophole for married participants in community property states to access retirement funds prematurely, thereby putting at risk a dignified and secure retirement.
