When times get tough, as they often do during divorce, many people turn to their retirement accounts for a bridge loan to get them past temporary financial troubles. The problem, of course,is that a retirement account is considered the joint property of both spouses — and if one person borrows against that account, they are borrowing against both parties’ property.
How should loans against a 401(k), deferred compensation, pension, or other retirement account be treated in a divorce — and by extension, in your qualified domestic relations order? The treatment of the loan will depend on when the loan was taken out and what type of retirement account is at issue — a loan against a cash-based deferred compensation account during the marriage is treated differently than a loan after the divorce by the employee-participant against a pension.
Let’s review some common scenarios for these loans as well as some general rules that are applicable in most states. But as always, this is for informational purposes only, and you should check with your local family law attorney and QDRO attorney before acting on this information. Also, know that much of this discussion is about the default rules, but parties can agree to anything they want — one person can take on all of the debt, or no debt at all.
Marital Loan? Marital Debt
When was the loan taken out? If it was during the marriage, before your divorce, then it is likely a marital debt. This is just like when a married couple buys a house together, that house is marital property and the mortgage is a marital debt — a joint obligation of the parties. There may be exceptions to this general presumption: there are certainly cases where people have taken out a massive loan a couple of days before the divorce was filed or the parties separated, and spent that money on a new lover or something not in the best interests of the married couple and courts have looked unfavorably upon such withdrawals.
If you know of, or suspect, that such a loan or withdrawal was taken immediately before your divorce was filed, this is something that should be addressed during the divorce process. The parties to the divorce can demand discovery, such as copies of all statements, loans, withdrawals, and other transactions that have been undertaken by either party to their retirement accounts in the time leading up to the divorce, as well as the time since the parties separated. The parties can look at those statements and discuss what the loans or withdrawals were used for, and if the issue is addressed proactively, their lives will be a lot easier when it comes time for the QDRO.
Post-Separation Loan? Employee Pays
In many cases, after the parties have separated and the divorce proceedings have commenced, the financial strain of starting a second household and supporting both households makes it difficult for the parties to keep up with their expenses. Once you add in legal fees, it becomes nearly impossible for most people.
Many people will borrow from their retirement account to help fund their divorce, whether it is to catch up on support payments or to pay legal fees. The wisdom of this from a financial perspective is a matter for you to discuss with a financial advisor. And, it should also be stated that, in many states, it is a violation of automatic court orders to take anything out of these accounts once the divorce has been filed. (In California, for example, these are called automatic Temporary Restraining Orders – ATROs, for short.) Nonetheless, it happens.
Marital Loans Against a 401k or Deferred Compensation Account
Loan was before the divorce commenced
For these debts that were incurred during the marriage but before the divorce was filed, if the parties haven’t agreed to treat the debt differently, it will probably be seen as a debt from the marriage. When it comes to drafting a QDRO to divide a deferred compensation account (which includes 401(k), 401A, 403(b), and most other cash-based retirement accounts), the marital loan balance as of the property division date is typically subtracted from the overall balance of the account, and anything left is divided between the parties.
For example, most people go with a 50-50 split of the marital portion of that retirement account. If the account is worth $100,000 but there is a $20,000 loan against the account, then the parties will split $80,000 instead—$40,000 each—and the loan will stay with the employee-participant, along with the obligation to pay back that loan.
Loan was after the divorce commenced
If the employee-participant spouse borrows money from the account after the couple has split up, this is usually seen as a separate loan and the employee’s responsibility. The sole burden of paying back this loan goes with the employee, and it is not factored into calculations of the other party’s share of the account.
For example, if there is a $100,000 account and the employee has borrowed $20,000 against it, the parties will still split $100,000 – $50,000 is paid to the non-employee/alternate payee — and the employee will be responsible for the $20,000 loan.
In most cases, this default rule is enough: the loan by the employee can be assigned to them and there is enough money left in the account to pay the alternate payee’s share. But if loans are a concern, the alternate payee should be careful and follow up with the plan after the order has been carried out to find out how the numbers were calculated. If there was an insufficient balance in the account to pay out the alternate payee’s share, the order will often be interpreted to simply mean the entire account balance and not all plans will be transparent about the fact that they are paying less than the math indicates they should have.
Marital Loans Against a Pension
When it comes to timing, pension loans are similar to 401(k) loans: loans before the divorce date are likely marital and a joint responsibility, while loans after the divorce date are likely the sole obligation of the employee. The problem comes with apportioning that loan: many plans cannot or will not assign that loan to one party or the other — and many will resist any order language that would require them to split the loan between both parties.
If there is any indication the loans have been taken out on a pension plan, the parties should consider addressing it proactively by paying off the loan. That is the cleanest way to ensure that nobody’s pension benefits are affected by a loan. Otherwise, if there is an outstanding loan at the time either party begins receiving benefits, their monthly pension payment will likely be reduced for life.
If the loan cannot be paid off before a Qualified Domestic Relations Order (QDRO) is drafted for the plan, the person drafting the order can attempt to put in language that assigns the loan where it belongs – jointly, if it was marital, or to the employee, if not. Some plans will accept this and can assign the loan. And the time to at least try to work this loan assignment language into the order is during the preapproval stage (where a rough draft QDRO is sent to the plan for review of the language before everyone signs and it is executed by the court). If the plan accepts the language, you know that they can divide the loan as needed. If the plan rejects your rough draft, they will typically include a letter explaining why (likely something about being unable to apportion loans).
Prohibit Pension Loans in the QDRO
Another important thing to include in the QDRO with regards to pension loans is a prohibition on taking out further loans against the pension until retirement. This is especially important for plans that do not recognize separate interest pension QDROs or for plans that cannot split or assign loans as part of a QDRO.
For example, a client came to me with a request for a QDRO on a local teacher union plan. That plan only recognizes shared interest orders (where the alternate payee gets a percentage of every check). This meant that any loans taken out against the pension would affect her share if they were still outstanding at the time of the employee’s retirement. He admitted that he took out loans after the date of the divorce. The union plan would not allot the loans to him alone. The best we could do with this particular union was to put language into the order that prevented him from taking out any additional loans, and if he didn’t pay off the existing loans by the time of retirement, that particular alternate payee would have to return to court to be made whole in some other way.
Loans Are Complicated
If you are looking for actionable advice on loans against retirement accounts before you proceed with a qualified domestic relations order, the biggest piece of advice is this: get plan statements. If you have monthly or quarterly statements going back to at least the time of your separation, there will be fewer surprises when we draft the QDRO.
Also, don’t wait to do your QDRO. Many people will wait, and withdrawals or loans impact their share. Frequently, old records will be lost, including from the banks themselves, making it difficult to find out what loans existed at the time of divorce. Language can be put into the QDRO now to prevent future damage to the account, and in many cases, your interest in the account can be secured today, leaving each spouse to do whatever they need to with their share of the account without affecting the other party’s share.
Finally, if you do know that loans are going to impact your QDRO, discuss the matter proactively with your QDRO attorney and let them know about the issue so that it can be addressed in the order language. If you are in one of our seven states, you can schedule a free consultation with us, and we will talk through your loan and QDRO issues with you.