Common types of retirement benefits
divided in divorce cases
By Joy M. Feinberg The divorce practitioner must be knowledgeable in a multitude of areas to
competently handle any case. The financial arena shelters a multitude of minefields for
all of us, and few of them are as treacherous as the valuation and division of retirement
benefits. Since these benefits are often the largest asset a divorcing couple must divide,
careful planning is required. In order to be prepared to handle these matters with enough
skill to assure your clients of receipt of all benefits due them as well as a just
proportion of those benefits, one must begin with a full knowledge and understanding of
the many differing types of benefit plans available.
Differentiating
between the two types of plans
DEFINED CONTRIBUTION PLANS
Two different types of plans exist in the mainstream of retirement benefit plans: DEFINED
CONTRIBUTION PLANS and DEFINED BENEFIT PLANS. Defined Contribution Plans (DCPs) are the
types of plans where the Participant, or employee, has their own "Account
Balance", even if the funds are not segregated into separate accounts for each
employee. The general fund is valued at least annually and the Participant receives a
statement of his/her interest in that plan. Thus, it is relatively easy to obtain an exact
value of the Participant's interest in these plans. When the participant leaves the employ
of the company, plan balances may be transferred to the new company's similarly styled
plan, to an IRA or other such instrument of the individual or the funds may be withdrawn
and paid to the individual. If the individual chooses to withdraw his/her funds before
reaching age 62 ¸, the funds withdrawn are taxed at ordinary income rates AND in
addition, a 10% penalty (of the entire sum withdrawn) for early withdrawal is added to the
taxes paid as an incentive to keep your funds in a retirement account. Examples of types
of DCPs are: Profit Sharing Plans, stock Bonus Plans, Money-Purchase Pension Plans, Thrift
Plans, Savings Plans, Cash and Deferred Salary Reduction Plans, 401(k) Plans and Employee
Stock Ownership Plans (referred to as ESOPs).
Defined Contribution Plans may be divided by using
Qualified Domestic Relations Orders and transferring the non-participant's interest into
that person's own IRA or account balance at their own employer equivalent plan. While
Defined Contribution Plans are not required to provide Qualified Joint and Survivor
Annuities or Qualified Pre-Retirement Survivor Annuities, securing the non-participant's
interest up until the date the funds are transferred from the Participant's account to the
non-participant's account is crucial. The method of providing this type of protection can
be found in the sample QDRO in this issue of the Family Advocate prepared by Wayne S.
Jacobsen, an ERISA practitioner in Newport Beach, California.
DEFINED BENEFIT PLANS
DEFINED BENEFIT PLANS (DBPs) with the emphasis on "BENEFIT" are more difficult
to value. These plans refer to a Future Stream of Payments, based upon a BENEFIT FORMULA,
as opposed to a calculable account balance, and, although funded by employer contributions
calculated by the Plan's actuarial calculations, do not begin paying out until the
employee or former employee retires. Typically, these plans take the average earnings of
the Participant Employee over his/her last 5 years of service with the company and
multiply that sum by the years of service put in by the employee and certain other factors
to arrive at a monthly stream of payments to be paid to the Employee Participant upon
his/her retirement. The Employee Participant may have a variety of payout methods to
select from, including payments made over a single life (i.e. for as long as the former
employee lives); a joint and survivor annuity (for as long as the former employee lives
and, independent of the former employee's life, for as long as the joint annuitant lives);
a 10 year guaranteed payment etc. Each of the choices offered will affect the monthly
annuity paid. A Joint and Survivor Annuity, because it is to be paid over the risk of 2
lifetimes will necessarily be a lesser sum than a single life annuity. Under the
Retirement Equity Act of 1984 (REA), both ERISA and the Internal Revenue Code were amended
to provide that Qualified Retirement Benefit Plans (such plans include: Defined Benefit
Plans, Money Purchase Plans and Target Benefit Plans) must pay certain benefits to a
married plan participant and his/her spouse. If the participant dies BEFORE retiring, this
benefit is called a Qualified Pre-Retirement Survivor Annuity (QPSA), and if the
participant dies AFTER retiring, the benefit is called a Qualified Joint Survivor Annuity
(QJSA). These benefits are crucial to secure when dividing Defined Benefit Plan interests
when representing the non-participant spouse. Not including surviving spouse language in a
Domestic Relations Order would be putting the non-Participant spouse's interest at risk of
loss and would be tantamount to malpractice. This concept is discussed in Daniel N.
Janich's article entitled, "QDROs and Surviving Spouse Protection: What happens When
the Participant Remarried?" elsewhere in this Family Advocate issue. This issue of
the Family Advocate also contains two sample QDROs prepared by ERISA expert Wayne S.
Jacobsen of Newport Beach, California. Waiver of a QPSA or QJSA require strict compliance
with the REA rules and are discussed in detail in Ann Pachciarek and Julie LaEace's
article on Waiver of Interests in Qualified Retirement Plans in Pre-Marital Agreements
elsewhere in this issue of the Family Advocate.
Valuing
the defined benefit plan interest
The concept of valuing the Participant's current interest
in a Defined Benefit Plan involves determining how much money would be required to be put
into a bank account TODAY in order to provide enough money to pay the monthly sums for the
lifetime of the Participant at the time the employee-Participant retires in the future.
This valuation process is predicated upon a number of assumptions, such as the
employee-Participant's age of mortality; future interest rates adding to the value of the
funds, etc. To arrive at a PRESENT VALUE of the DBP, you will likely call upon an expert
witness, such as a CPA or an Actuary to give you a report of value. How this valuation is
accomplished and how one works with such an expert is covered by Sandor Goldstein's
excellent article included elsewhere in this Advocate Issue.
Negotiating the division of a DBP should include more
than merely dividing the annuity payment by use of a Qualified Domestic Relations Order.
There are other pieces of the benefits to divide, such as surviving spouse benefits; early
retirement buy-out offers; cost of living adjustments (COLAs); and other subsidies.
Understanding
certain special types of plans
IRAs come in many varieties today. A simple IRA is
available to an individual who is not a participant in an employer sponsored plan or to
the individual who has less than $ _______ set aside by their employer in that particular
year. Individuals can place $2,000 annually into an IRA, whether or not they have been
employed in any capacity during the year.
SEP IRAs can be instituted by any C or S corporation,
partnership, sole proprietorship or self-employed individual. The employer can restrict
eligibility to those over 21 years. Some part-time workers under a defined salary limit
can be ineligible from participation. Union workers under a collective bargaining
agreement can also be ineligible from participation. Ineligibility can also be limited to
those who have worked 3 out of the last 5 years. The contributions, made solely by the
employer and directly into each individual's IRA, can vary from year to year and can even
be discontinued, so long as contributions and discontinuation are allocated in a
non-discriminatory manner. Each individual employee can receive up to 15% of their pre-tax
income into the plan with an annual maximum. The maximum is adjusted annually for
inflation and is currently about $24,000. Loans are NOT permitted in this type of plan.
The contributions are tax deferred until withdrawal.
Roth IRAs are NOT tax deferred funds. These are AFTER TAX
dollars deposited into a Roth IRA. All growth in the account is tax-free thereafter.
Educational IRAs are set up with AFTER TAX dollars for
the benefit of children under the age of 18. Funds can be removed from the account TAX
FREE after the child attains age 18 if used for higher educational expenses.
Defined
contribution styled plans
401(k) Plans are retirement savings plans that are funded
by pre-tax EMPLOYEE contributions and may include matching contributions from the
employer. Funds grow tax free until withdrawn. These types of Defined Contribution Plans
may be utilized by for-profit and many kinds of tax-exempt organizations, and the employee
is often free to direct his/her own investments. These funds are not accessible until the
participant reaches age 59 ¸ , except through payments of taxes and penalties. The plan
funds are not guaranteed by the Pension Benefit Guarantee Corporation. Employer
contributions may not vest immediately. Some of the limits of annual allowable
contributions depend on the number of lower paid employees participating in the plan.
Plans vary and certain plans allow for post tax earnings to be contributed to the
participant's account; however, such accounts are 401(a) employee savings plan accounts.
Employee savings plans allow for tax-free growth until withdrawal of after tax monies put
into the account. 401(k) accounts are limited to employee contributions of $10,500 in 2000
(again, this sum is adjusted annually for inflation) and this dollar limitation applies to
the total sum contributed by the employee, no matter how many different employers that
individual worked for in any given year. The annual limitation on total contributions to
all employee types of plans adjusts annually, but is approximately $30,000 or 25% of the
employee's total annual compensation, which sum cannot exceed the dollar maximum. 401(k)
plans usually allow access to funds through loans, limited to a certain dollar amount of
approximately $50,000 which must be paid back with interest over 5 years, although that
payback period can be extended to 15 years for the purchase of a principal place of
residence or an intended principal place of residence. One benefit of a 401(k) plan is
that if an employee retires or is "separated from service" during the year they
reach age 55 or more, the participant can withdraw any amount from his/her account without
penalties. Additionally, after reaching age 59 ¸, the participant, even if still
employed, may begin withdrawing funds so long as the plan allows same. Minimum withdrawal
rules, being 10% kick in beginning when the participant reaches age 70 ¸ if the
participant is no longer working at the company.
403(b) Plans are structured like 401(k) Plans; however,
the 403(b) plans are not "qualified plans" under the tax code. Rather, such
plans are Tax Sheltered Annuity Arrangements offered only by public school systems and
other tax-exempt organizations. 403(b) Plans are not limited by the anti-top heavy rules
of 401(k) plans. As such, there is no limitation imposed by "low earning" or
other individuals participating in the plan other than the participant. Employer
contributions, if any, have different limitations than under 401(k) plans. The 10% early
withdrawal penalty and the 15% excise tax for excess annual contributions apply to both
401(k) and 403(b) plans. Such plans include State Teacher Retirement System Plans and such
venerable institutions as TIAA-CREF.
TIAA-CREF is so often encountered, it is important to
take a moment to look at its features. The TIAA traditional Annuity guarantees to preserve
invested principal and to pay at least a contractually specified interest rate, and holds
the possibility of dividend payment. The TIAA Real Estate Account and all CREF accounts
are VARIABLE ANNUITIES that offer no guarantees on principal or investment returns. CREF
investments are directed by the participant into one of 8 types of accounts: stocks;
global equities; growth; equity index fund; social choice fund; bond market;
inflation-linked funds and a money market fund. TIAA-CREF also offers participants the
ability to participate in SRAs or Supplement Retirement Annuities in order to provide more
retirement funds. Often such employees have little or no individual Social Security
Benefits because they have not worked in the private sector long enough to secure such
benefits. Both TIAA and CREF accounts are divisible by QDRO; however, the plan provides
its own form QDRO for use and it is wise to have the division decisions made between the
client and his/her financial advisor rather than the attorney.
457 Plans are also a form of a non-qualified plan, but is
designed for deferring compensation for employees of states, counties, cities, agencies
and other political agencies. The purpose of these plans is to provide a tax favored
avenue for such employees to save for their own retirement. The employer contracts with
the employee to defer compensation to some future date for currently performed services of
the employee and this "promise to pay" is not secured by an institution such as
the PBCG. Annual salary deductions are limited to $7,500 or 33 1/3% of salary, whichever
is less. Payments are taxable as ordinary income and distributions are not allowed to be
rolled over into an IRA. Distributions occur upon retirement, terminations of employment
or death. Some plans may have an "extreme financial hardship" withdrawal
provision. Virtually every state has its own Public Employees Retirement System or Systems
and the rules for same are found in each state's statutes. These plans are not governed by
ERISA and are instead ruled both by state law and the provisions of the Internal Revenue
Code. Division can be extremely difficult, if not impossible. Many of the provisions
negotiated for ERISA covered plans, such as "surviving spouse" designation may
be inapplicable in these plans, but each one must be studied thoroughly.
SEPs or Simplified Employee Retirement Plans can be set
up at a bank or brokerage house based upon a pre-printed form plan document which requires
separate accounts for each participant. Each participant has their own account balance and
there is no waiting period for coverage. Employees who have not worked 3 out of the last 5
years need not be covered in these plans. SEPs may be set up and funds contributed in the
next taxable year up through the date that the tax return is due.
Keough Plans are either Money Purchase Plans or Profit
Sharing styled plans. The Money Purchase Keough allows up to 20% of earnings, with a
$30,000 annual maximum contribution to be contributed to the participant's account
balance. These contributions must be made EVERY YEAR. The Profit Sharing styled Keough
allows for a lesser maximum percentage of earnings to be contributed and contributions
cannot be based on earnings over $150,000 annually. Annual percentage variations are
allowed on Profit sharing styled Keoughs. Age 21 can be a minimum requirement for plan
participation and employees who have not worked for 1 year may be excluded along with some
part-time employees. Keough plans can limit vesting to 3 to 5 years or, if desires, a vest
schedule can be strung out over 7 years. Employees who leave before full vesting only take
vested benefits with them. Keough plans must be set up before year end, although
contributions may be made after year end up through the date the tax returns are due.
The
hybrids
There are certain types of accounts which have
characteristics of Defined Contribution Plans, yet are also akin to Defined Benefit Plans.
Such plans include Cash Balance Pension Plans; Pension Equity Plans; Life Cycle Pension
Plans and Retirement Bonus Plans; Floor-Offset Pension Plans; Age-Weighted Profit Sharing
Plans; New Comparability Profit Sharing Plans and Target Benefit Plans.
In a Cash Balance Plan, each participant has an account
that is credited with a dollar amount that resembles an employer contribution and is
determined by a percentage of the participant's pay. Interest is paid to each account.
Typically, benefits are paid as a lump-sum distribution or as an annuity. These plans
provide Defined Future Payable Benefits rather than employer contributions. While each
account expresses current lump-sum values of the participant's accrued benefit, in
actuality, the account is merely a bookkeeping device. Actuarial valuations control
employer contributions to the participant's account rather than the actual contributions
made to each account. Interest is credited at a specified rate and is UNRELATED to the
investment earnings of the employer's pension trust. The annual limits for contributions
are applied to the annuity equivalent of the cash balance account, rather than the amount
added to the account each year. Loans are permitted under these plans, but because this
would be difficult to administer, these plans do not usually allow loans.
Pension Equity Plans, like Cash Balance Plans define
benefits in terms of a current lump-sum value rather than a deferred annuity. The Pension
Equity Plan is a final average lump sum valuation determination and it does not have
individual accounts to which interest is credited annually. Each year of service credits
the employee with an ever increasing percentage that will be applied to their final
average earnings. Both lump sum benefits and annuities are methods of payment to the
employee upon retirement, depending upon the provisions of the plan.
Life Cycle Pensions Plans and Retirement Bonus Plans:
Like the Pension Equity Plan, Final Average Salary is multiplied by years of service
credits that are converted into a percentage figure.
Floor-Offset Pension Plans are actually 2 plans that are
interrelated. The FLOOR plan is the defined benefit plan and the BASE plan is the Defined
Contribution Plan. The Floor Plan establishes a minimum benefit level that is dependent on
the employer's objectives and constraints. If the defined contribution plan provides a
benefit that equals or exceed the minimum established by the defined benefit floor plan,
the participant receives the balance in the defined contribution account and NO benefit is
payable from the floor plan. The level of contribution from the floor plan will depend
upon the benefits payable from the defined contribution plans ability to meet or exceed
the established minimums.
Age-Weighted Profit Sharing Plans provide greater
benefits to older employees and are often used by smaller companies. These plans have an
age factor weighted into the formula allocating profit sharing funds to individual
accounts rather than being based solely on the percentage of the employee's salary.
New Comparability Profit Sharing Plans divide employees
into separate allocation groups to provide larger percentage contributions for certain
select employees.
Target Benefit Plans set a "TARGET" benefit for
each participant at normal retirement age, which is usually age 65, using a defined
benefit plan formula. Employer contributions are determined actuarially. Unlike a
traditional defined benefit plan, the target benefit is NOT GUARANTEED. Individual
accounts are established for each participant and investment decisions are usually left to
the employee, whose account gets the interest or losses generated by those investment
decisions. The employer only has an obligation to make the contribution required by the
plan formula. It is the employee who runs the risk of the investments yielding the
benefits anticipated by the investment strategy.
Non-ERISA
covered plans
Up to this point, virtually all plans discussed were
ERISA plans or ERISA styled plans. ERISA plans allow the employee to have PRE-TAX dollars
put into an account and grow TAX FREE until withdrawal. Non-ERISA covered or styled plans
do not have such benefits; nor are such plans guaranteed by coverage from the PBGC.
TOP HAT PLANS -- are unfunded plans maintained by
employers primarily for the purpose of providing deferred compensation for a select group
of management or highly compensated employees. These plans are designed to attract and
keep key employees and executives. Because these plans are unfunded, tax forms are not
filed annually. Finding these plans is difficult without disclosure or very specific
discovery requests to employers and employees alike.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLANS (SERPs) -- are
unfunded plans maintained by employers to reward and attract key executives. Top Hat Plans
are one such plan. The underlying assets in SERPs are considered corporate-owned and are
thus available for use by owners and creditors of the corporation. When corporations are
potential merger or takeover candidates, or, at times when facing bankruptcy, a single or
group fixed annuity is purchased by the corporation to secure these benefits for the key
employees. Again, specific requests for such information from the corporation and the
employee as well as the Benefits Director would be the avenue for locating such a valuable
asset.
RABBI TRUSTS -- are security devices, akin to an escrow
account, which contains segregated funds to be used for the purpose of securing
"unfunded" employer obligations to employees under one or more of its
non-qualified plans. It is an irrevocable trust established for the benefit of the
participant by the employer. Again, specific language in discovery requests to employers
and employees is required to ferret out these trusts.
Railroad
retirement plan
Military Retirement Systems and the Federal Employees
Retirement System (FERS) are discussed elsewhere in this Family Advocate issue in an
article by Mark Sullivan of Charlotte, North Carolina. There is one other type of plan not
elsewhere discussed: the Railroad Retirement Plan, another non-ERISA plan. This plan has 2
types of benefits: Tier I, which is equivalent to Social Security and Tier II, which is a
defined benefit styled plan. Only Tier II benefits can be divided and these benefits
CANNOT be used for spousal support or child support collection. The Railroad Retirement
Board provides its own form G-177d with model language for inclusion in a Judgment of
Dissolution of Marriage, as no separate instrument, such as a Domestic Relations Order is
required to divide these benefits. Parties must be married for 10 years immediately
preceding divorce before the spouse can obtain any benefits.
The
importance of section 72(t)
The Internal Revenue Code provides a special tax
exception for the distribution of ERISA pension benefits prior to age 59 ¸ to a spouse or
former spouse when incident to divorce via section 72(t), which provides that the 10%
penalty on the entire sum withdrawn is waived. The taxes on the sum withdrawn are not
waived and must be paid over and above the 20% withheld by the plan and forwarded to the
IRS. Practitioners should check their local state taxation rules as a number of states do
not tax retirement distributions.
Joy M. Feinberg of Feinberg & Barry, P.C. has
practiced family law in Chicago for more than 20 years. She is past-president of the
Illinois Chapter of the American Academy of
Matrimonial Lawyers. She can be reached at (312) 444-1050. View her firm's Divorce Magazine
profile here. |
