Retirement plan loans are one of the most complicated aspect of QDROs to understand and handle correctly. A retirement plan loan is not actually “debt” as most attorneys understand that term. Instead, retirement plan loans can be thought of as a distribution, and generally should not be equalized with other types of debt (like credit card debt) in a family law divorce case. Here’s why.
When a participant from a retirement plan applies for a loan, the participant’s investments are sold in order to pay out the loan proceeds to the participant. Conversely, when the participant repays the loan balance, the participant retains their own loan payments and interest. Thus, in general, the account balance of a retirement plan already reflects a reduction for the loan.
It’s Important to Ensure One Party Is Not Hit Twice Financially
This can be a complicated analysis and not every plan is the same, but it is important to remember if there is a retirement plan loan, special attention should be given to make sure that one party is not hit twice with the financial aspect of the loan. Below is some common Marital Settlement Agreement language that may be helpful with regard to handling a retirement plan loan (see bolded sentence).
The parties agree that there is a community property interest in Husband’s [PLAN NAME]. The community property interest shall be determined by taking the account balance as of the Date of Separation, plus any contributions made after the Date of Separation that were earned during marriage, and adjusting that balance by investment earnings or losses in the Plan assets from the Date of Separation until the final date of distribution to Wife. Wife shall receive a 50 percent (50%) assignment of the community property interest using a Qualified Domestic Relations Order (“QDRO”). Any loans taken out during the marriage shall reduce the community property interest. The parties agree to jointly retain [QDRO ATTORNEY NAME] to be the neutral attorney to prepare the QDRO. The parties shall each pay half of [QDRO ATTORNEY NAME] fees and agree to cooperate with the QDRO process including providing all documents and information necessary for the preparation of the QDRO.
As always, different language may be appropriate on a case by case basis if there are unique facts.
When a participant takes a “loan” from their retirement plan, the plan liquidates investment assets in order to pay the participant cash from the plan. This means that when an account statement for a 401(k) plan states: asset balance $15,000, loan balance $5,000, there is actually still $15,000 worth of community property investments in the plan. It is worth noting that different banks report plan loans differently on statements, so the treatment of the loan should be double checked with the bank prior to arriving at a firm conclusion.
Arguably, a loan should not be thought of as a debt at all. Instead, it is way of cashing out pre-tax dollars from a retirement plan. The reason that a loan is not a debt is the subsequent loan payments made by the participant to repay the loan increase the participant’s plan balance. In other words, the participant is simply transferring funds from their checking account to their retirement plan. They are repaying themselves.
Despite the conclusion that a retirement plan loan is not truly a “debt,” there are special tax and transferability considerations to be taken into account. A participant loan is accompanied by a tax disadvantage for the participant who retains the plan because a participant repays the loan with after-tax dollars and then the participant is ultimately taxed on the benefits when they are withdrawn at retirement. Furthermore, a QDRO cannot assign a participant loan from the participant to an ex-spouse. Parties in mediation or preparing for trial may benefit from a brief analysis on how to equitably treat a retirement plan loan which can depend on the specific facts and circumstances.
The bottom line is that a retirement plan loan is unique and not generally treated as a community property debt obligation.
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