How to Divide Deferred Compensation Accounts in a Divorce

Dividing tax-sheltered assets, such as deferred compensation accounts, in a divorce requires care. Many couples realize that, to avoid costly mistakes, splitting these accounts is best accomplished with the help of lawyers and accountants. The exact process for dividing accounts in a deferred compensation plan may vary depending on the plan specifications and state law.

Plan Basics

A deferred compensation plan allows an employee to set aside a portion of his income to be paid out at a future date. There are two types of deferred compensation plans: qualified and non-qualified. In a qualified plan, deposits and earnings qualify for special tax treatment under IRS regulations. Qualified plans include benefits that are allowed to mature tax-deferred until they are dispersed. Although a qualified plan is not a retirement plan, many employees use it as a retirement savings vehicle because it can be rolled over into an Individual Retirement Account. IRS regulations may prohibit the highest earners in a company from participating in a qualified plan. With a non-qualified plan, the employer cannot deduct the deferred compensation on its taxes until the employee withdraws the money as income and pays taxes on it. A non-qualified plan costs less to establish and administer than a qualified plan.

State Law

State law determines what interest, if any, one spouse has in another spouse's deferred compensation account. In a community property state, a spouse may automatically have an interest in an account created during the marriage. In other states, the spouse whose name the account is in may keep the entire deferred compensation account and offset its value at the time of divorce against a similarly valued asset that the account holder's spouse retains in the divorce.

Premarital Account

If an individual had an interest in a deferred compensation account at the time the couple got married, the account holder's premarital interest may be separated from the marital portion of the account before the account is divided and distributed. If that is the case, the premarital portion of the plan will be adjusted to take into account earnings or losses on the premarital balance. The couple may hire an accountant to make these calculations; they may have to obtain account records from the plan administrator to accurately identify the premarital portion of the account.

Qualified Domestic Relations Order

After the parties determine what the marital portion of the account is and decide how they will divide it, their attorneys prepare a Qualified Domestic Relations Order that a judge will sign. If they cannot agree on a division, a judge will enter a QDRO after a trial or hearing. The QDRO creates a separate account for the benefit of the non-account holder spouse and deposits that spouse's share of the deferred compensation account into the newly created separate account. This enables the couple to divide the account without forcing either the husband or the wife to pay taxes and penalties for early withdrawal.