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Retirement as Deferred Compensation: What the Divorce Lawyer Needs to Know Regarding Qualified and Nonqualified Plans

By Joseph DiPiazza

Retirement savings often comprise a substantial component of marital assets in a divorce. For executives and other high-income earners, there may be additional deferred compensation beyond traditional 401(k) or IRA accounts due to the simple fact that yearly contributions to those accounts are limited. Additional options for deferred compensation present high-income earners with an ability to save for retirement in a way that is commensurate with the lifestyle they have been afforded as a result of their employment. Deferred compensation plans can fall under one of two categories: qualified or nonqualified. Both types delay payments to employees—allowing them to defer tax until they have an unrestricted right to the funds. This article discusses both types of plans, as well as what the family law practitioner must understand and consider when valuing and dividing these assets during a divorce.

Qualified Plans

Qualified deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act of 1974 (ERISA). ERISA is a federal law that sets minimum standards for most voluntarily established pension plans in the private sector and provides protection for individuals in these plans. Qualified retirement plans can be defined contribution plans or defined benefit plans.

Qualified Defined Contribution Plans

The way that a defined contribution plan works is that either an employee or an employee and the employer make contributions into the plan, usually based on a percentage of the employee’s annual earnings. Each participant has an individual, separate account. The defined contribution plan category contains a broad range of possibilities; the most common options include 401(k) plans, 403(b) plans, profit-sharing plans, and two types of plans popular with small businesses: SIMPLE plans (savings incentive match plans for employees) and SEPs (simplified employee pensions).

Among the most well-known types of qualified retirement plans, a 401(k) is a defined contribution retirement savings plan sponsored by an employer. Under a 401(k), employees save and invest a portion of their paychecks before taxes are taken out. The amount of the contributions is decided by the employee and sometimes matched by the employer. As of 2018, employees may make a maximum pretax annual contribution of $18,500. Taxes are not paid until the money is withdrawn or distributed from the plan. There are penalties if the employee withdraws before reaching a certain age.

Another kind of defined contribution retirement plan is the 403(b), which is available for employees of government and tax-exempt groups, such as schools, hospitals, and churches. These plans are less common than 401(k) plans but are fundamentally the same and are also subject to ERISA guidelines. Contributions are made pretax and are only taxed when withdrawn from the plan.

Profit-sharing plans are another type of qualified deferred compensation. In a profit-sharing plan, an employer makes a contribution of stock or cash to an account each year, calculating the contribution based on the company’s net income. Employees must maintain their employment over a period of time to gain rights to the benefit. Profit-sharing plans must meet a variety of requirements to qualify for preferential tax treatment under ERISA.

In general, individual retirement arrangements fall outside of ERISA’s realm. Employer-sponsored IRAs, however, are an exception. Some small- to mid-sized businesses provide retirement plans to their employees via a SEP. Under a SEP, employers contribute directly to IRA accounts established by the employees. These plans are ERISA qualified because the employer realizes the tax benefits of the retirement contribution. Another employer-sponsored plan is the SIMPLE plan, which allows employers to contribute to traditional IRAs established for employees. Employees may also contribute. Due to the employer’s involvement, SIMPLE IRAs are governed by ERISA.

Qualified Defined Benefit Plans

A defined benefit plan is a retirement account in which the employee accumulates credits towards his or her retirement based upon length of service and the salary he or she earned at the time of retirement. When one thinks of traditional pension plans, i.e., those that provide set monthly payments to employees either for life or for a set term, one is usually thinking of a defined benefit plan. Defined benefit plans are qualified employer-sponsored retirement plans. Like other qualified plans, they offer tax incentives both to employers and to participating employees. Accordingly, all qualified defined benefit plans must comply with ERISA guidelines.

Dividing Qualified Plans in a Divorce

Divorce agreements and judgments allow the transfer of qualified plan assets by the ex-spouse of the plan owner if the spouse uses a qualified domestic relations order (QDRO). The receiving spouse may roll QDRO assets into his or her own qualified plan or into a traditional or Roth IRA. Any transfer from a qualified plan pursuant to a divorce settlement that is not deemed a QDRO by the IRS is subject to tax and penalty.

Dividing Qualified Contribution Plans

The main focus when dividing retirement assets in a divorce is on determining which assets were accumulated during the marriage. Generally, any assets accumulated during the marriage belong to both spouses. With that being said, there are several methods of dividing defined contribution plans. The parties may elect an offset, where the employee spouse avoids any division by agreeing to substitute a lump sum, alimony, or other assets for the plan benefits to which the other spouse would be entitled. Another option is a simple division, in which the QDRO sets forth the percentage of the plan belonging to each spouse. Finally, the parties may elect a deferred distribution. This entails delaying division until the spouse who owns the account actually retires.

Dividing Qualified Benefit Plans

Although the division of defined benefit plans may be accomplished by the same or similar methods, this may prove more difficult. Unlike other retirement accounts, dividing a pension entails placing a value on what the pension might be worth in the future. Moreover, some pensions are not guaranteed until the employee spouse has worked for the company for a certain number of years. Thus, there is technically no account to divide at the time of divorce. Therefore, deferred distribution is often used by family law practitioners in the division of defined benefit plans. If an immediate offset is required, this will require a pension evaluation by an accredited actuary.

Nonqualified Plans

Nonqualified deferred compensation (NQDC) plans are tax-deferred, employer-sponsored retirement plans that fall outside of ERISA guidelines. These plans are commonly referred to as 409(a) plans (or “golden handcuff” plans, as they often contain forfeiture provisions if the employee separates from the company, thus becoming a powerful tool for binding the employee to the employer). Unlike qualified plans, NQDC plans are not constrained by contribution limits.

NQDC plans are used by employers for a variety of reasons, namely to attract and retain key employees, to ensure long-term commitment by senior management, to act as an executive supplement to the employer’s 401(k) plan, or to provide an alternative to making key employees partners or owners of the company or corporation. These plans are designed as a means of allowing executives to defer current income (and current taxation) until retirement or some other date when income may be lower and thus subject to a lower marginal tax rate.

Although the types of NQDC plans vary, all plans share common fundamental principles. Under NQDC plans, employees agree to defer a portion of their annual income until a specific date in the future. Some plans provide for the deferral of salary, others involve a deferral of bonus and/or incentive compensation, and many include both features. Depending on the plan, the deferral date could be in a fixed number of years or upon retirement. Moreover, distributions from NQDC plans are taxed to an employee at ordinary tax rates when they are distributed or made available to the employee. If FICA taxes were not withheld in the year of the deferral, they will be withheld when paid. Because NQDC funds are part of a company’s assets, the funds are subject to creditors’ claims in the event of a corporate bankruptcy.

The IRS categorizes NQDC plans as either account balance plans or nonaccount balance plans. An account balance plan uses an escrow account to segregate each employee’s deferred compensation account balance on the company’s books. An account is kept for each participant. The amount an employee elects to defer is credited to this account, along with related earnings. The employee’s future payments under the plan are based on the contributions and earnings credited to this account as deferred compensation. An example of such a plan is what is known as a “defined contribution supplemental executive retirement plan” (DC SERP). A DC SERP provides periodic contributions to an individual employee account. The money remains invested for the employee until retirement or death or a disability triggers payment.

A nonaccount balance plan does not use accounts or record employee deferrals, contributions, or investment earnings. Instead, the employer promises to pay a future benefit of a specified amount; this kind of plan, therefore, would be similar to a defined benefit plan. The difference from the qualified defined benefit plans discussed above is that these nonaccount balance plans are not qualified and, therefore, are not governed by ERISA guidelines. An example of such a plan is a defined benefit supplemental executive retirement plan (DB SERP). A DB SERP is a future promise of the employer to an employee to pay a specific amount of retirement income. A common form of a DB SERP provides a benefit upon retirement in the form of an annuity that, when added to the employee’s projected qualified retirement plan and Social Security benefits, will equal a specified percentage of the employee’s final average compensation.

Dividing Nonqualified Plans in a Divorce

Generally, dividing NQDC plans in a divorce will require determining the nonemployee spouse’s share of the plan benefits. Measuring the value of a NQDC plan will depend on whether the benefit is based on an account balance or non-account balance plan. Account balance plans are simpler to measure and are more likely to be available as an immediate lump sum. As such, these plans can be divided so as to allow a nonemployee spouse to receive a buyout of present value, as opposed to future entitlement. The family law practitioner must be aware that federal and possibly state income taxes may affect the value of the benefits; accordingly, this must be discussed in any present-value calculation. Other factors that may impact a present-value calculation include the employer’s risk of default, as plan assets are subject to the claims of creditors; any investment options that may continue to be available under the nonqualified plan and are not available outside the plan; and potential changes in future tax rates, e.g., the sunset provisions of the Tax Cuts and Jobs Act. It is recommended that a CPA be involved during the negotiation of any divorce agreement.

Nonaccount balance plans are more difficult to value and are less likely to be available as an immediate lump sum. As with defined benefit plans, converting a future benefit paid as a life annuity to a present value generally requires the services of an accredited pension actuary. Therefore, many parties agree to receive their entitlement to these plans at the time the distributions are made. Under this scenario, the risks inherent in the plan are shared by both parties. The family law practitioner must consider how payments to the nonemployee spouse will be calculated when the employee takes distributions. Federal income taxes, FICA taxes, and state income taxes may also reduce the value of the benefits at the time of distribution. Other factors to consider include the application of tax rates, determination of the nonemployee spouse’s entitlement when the employee is several years away from retirement, and the selection of investment options pending distribution. Again, it is recommended that a CPA be involved during the negotiation of any divorce agreement.

The Use of Domestic Relations Orders

Whereas a QDRO is used in the division of qualified deferred compensation plans, a domestic relations order (DRO) may be used in the division of nonqualified plans. Treasury Regulation section 414(p)(1)(B) defines a DRO as

Any judgment, decree, or order (including approval of a property settlement agreement) which relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant, and is made pursuant to a State domestic relations law (including a community property law).

In addition, Treasury Regulation section 1.409A-3(j)(4)(ii) allows, but does not require, acceleration of payments under a nonqualifed plan to comply with a DRO.

A plan may provide for acceleration of the time or schedule of a payment under the plan to an individual other than the service provider, or a payment under such plan may be made to an individual other than the service provider, to the extent necessary to fulfill a domestic relations order (as defined in section 414(p)(1)(B)).

Employers exercise varied approaches to DRO distributions from NQDC plans. Some employers carry plans that allow acceleration of the time or schedule of a payment of benefits to an alternate payee under a DRO. Other employer plans have strict anti-alienation provisions and impose penalties, such as forfeiture of benefits, for attempts to assign benefits.

When immediate lump sums are available, a nonqualified plan may be an asset to help settle a divorce through acceleration of payments to the nonemployee spouse. First, the NQDC plan must have provisions allowing such acceleration. The family law practitioner must request a copy of the plan document and confirm the employer’s policy on accelerating benefits pursuant to a DRO. Next, the family law practitioner must ascertain if a plan administrator exists and if such an administrator would be able to specify the information required to be included in the DRO. If no established procedure exists, the family law practitioner must exercise attention to detail in drafting a DRO. The DRO does not necessarily need to fulfill the technical requirements of a QDRO, but using those requirements as a guide may be advantageous in obtaining the desired payments. QDRO requirements include, for example, the name and last known mailing address of the participant and each alternate payee; the name of each plan to which the order applies; the dollar amount or percentage (or the method of determining the amount or percentage) of the benefit to be paid to the alternate payee; and the number of payments or time period to which the order applies.

In situations where acceleration of payments to the nonemployee spouse are not available or a DRO may not be used to obtain funds for settlement, the family law practitioner may also consider substituting other marital assets for the plan values, negotiating increased spousal support payments, or creating a trust into which the NQDC benefits would be paid. The trust may pay income tax upon receipt of the income and the remainder may be divided by the parties. In any event, the parties should be encouraged to remember that NQDC benefit payments are not guaranteed. Thus, in any arrangement considering the offset of marital assets, the parties must take into consideration the risk of forgoing an existing asset for one that may never come to pass.

Conclusion

With the various forms of retirement assets that may be at issue in a divorce, it is crucial that the family law practitioner understand the differences between qualified and nonqualified deferred compensation plans. While the division of qualified plans pursuant to a QDRO is relatively straightforward, nonqualified plans are often more difficult to divide. It is incumbent upon the family law practitioner to obtain extensive discovery of any compensation arrangements of a spouse who is an executive. This should include, without limitation, all NQDC plan documents, benefits statements, and the employer’s policy on a distribution from its NQDC plan or plans pursuant to a DRO. It is important for the family law practitioner to understand which payments under a NQDC plan may be accelerated or delayed, as this may present opportunities for structuring a settlement.

Joseph DiPiazza, an associate at Lesnevich, Marzano-Lesnevich, Trigg, O’Cathain & O’Cathain, LLC, in Hackensack, New Jersey, and New York City, devotes his practice exclusively to New Jersey family law matters and appellate practice. He is an associate editor of the New Jersey Family Lawyer and the author of recent articles on collaborative law, settlement, and alimony reform. DiPiazza is also an active member of the New Jersey State Bar Association and the Bergen County Bar Association, where he serves on both the Family Law Committee and Bergen Barrister Committee. He has been recognized by Super Lawyers as a 2017 and 2018 Rising Star.

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