This is one of those questions that UK-trained and UK client-focused advisers who only look after American expat clients occasionally say they come up against from time to time – and often end up having to consult an American wealth management specialist, in order to know how to respond.
It concerns the splitting of the assets of a married expatriate American couple, after they have been living abroad for more than a decade; have acquired dual citizenship – in this case, British and American – so that the couple can be free to enter into other relationships if they choose to.
In this instance, the couple, both American by birth, were married 25 years ago in the US, and came to the UK in 2001. The adviser who posed this question is based in the UK, and we decided to seek out an American expatriate advice expert for an answer: R. Stanton Farmer of Madison, Wisconsin-based Thun Financial Advisors (pictured, below).
Below is this London-based adviser’s query in full, followed by Farmer’s detailed response.
“Splitting the husband’s UK pension has proven easy: the pension scheme administrator is happy to take a divorce decree from a UK court.
“But the husband’s US pension is proving far trickier, and has been holding up the divorce, the couple tell me, for years.
“The manager of this gentleman’s US pension, Vanguard, wants a US court order, which would involve considerable expense on my client’s part, I am told: ‘tens of thousands of dollars’ was the quoted amount.
“What I wanted to know is whether there is a way to split my client’s U.S. pension without having to obtain a court order – perhaps by using some kind of fund wrapper, through a company like Pershing?
“The client is also insistent that it be done without incurring tax, or significant other charges; I have told him that I believe this should be possible.
“What would you suggest?”
For R. Stanton Farmer’s response, see page 2.
R. Stanton Farmer’s response:
Unfortunately, you may need to delicately re-position your analysis for your client, because the US legal requirements for tax-free divisions/transfers of qualified pension assets incident to a divorce will require at least some judicial involvement in the United States, and the blessing of the pension plan’s administrator.
Moreover, as any US custodian is going to be very mindful of ERISA [the Employee Retirement Income Security Act], IRS and state law requirements for a lawful, enforceable division of retirement account assets upon divorce, there is no creative fund or account maneuvering (as suggested by your question) that will effectively accomplish a tax-free transfer of pension assets from one spouse to another.
However, if the US pension assets (such as a 401(k) or 403(b) or profit sharing pension plan) are eligible for a rollover to a rollover IRA, the ERISA rules that apply to qualified plan division incident to a divorce may be avoided after first accomplishing the rollover, and thereafter only the tax code requirements for a tax-free property transfer “incident to divorce” will apply.
In such instances, it is entirely possible that a foreign divorce decree will be sufficient to authorise the IRA custodian to transfer assets from the client’s rollover IRA to an IRA in the name of the client’s ex-spouse.
Tread carefully, as missteps here by the client can prove quite costly, as any transfer to the recipient-divorcing spouse’s account from the client’s pension or IRA account that does not meet the operative US legal requirements will result in a taxable distribution for the client/transferring spouse.
Determining the possible course first requires a closer look at the underlying rules governing qualified US pension plans, such as 401(k), 403(b) or profit sharing pension plans.
Pursuant to the Employee Retirement Income Security Act of 1974 (ERISA), a US-qualified plan account cannot be assigned or alienated. This federal law preempts state law regarding property settlements incident to separation or divorce (as prescribed by state legislatures and interpreted by state family law courts).
QDROs in divorce proceedings
To accommodate the reality that pension assets may be the most substantial asset a couple may own, and that equity often demands a mechanism to divide the pension asset(s) of a divorcing couple, Congress passed the Retirement Equity Act of 1984, which permitted pension administrators to carry out qualified domestic relations orders (QDROs) and thereby divide pension benefits.
A QDRO must be a state court judgement, decree or order relating to child support, spousal maintenance or marital property rights.
A foreign divorce judgment is not a QDRO – a state court’s involvement is necessary, as made clear in ERISA bulletins from the US Department of Labor on the subject.
The QDRO will also need to be acceptable to the plan administrator (because the administrator is responsible for determining that the ERISA requirements for a valid QDRO have been met) – and here is where practical advice must direct the client towards working with the plan administrator, rather than trying to find a legal path or “work around”, and later presenting it to the plan administrator, and hoping that it is found to be acceptable.
Plan administrators often can provide sample or model or form QDROs, from which you can proceed toward the proper state court to provide official sanction.
As the couple live in the UK and therefore may not have a logical “jurisdiction” back in the US in which to initiate a legal action, the state court within the locale of the pension’s administrator might be the appropriate venue – but, again, the administrator may be able to provide guidance.
Ultimately, a UK divorce decree that includes a division of UK pension assets and also US pension assets will not have ultimate effect unless and until that judgement is registered in at US state court, and that state court issues a valid QDRO consistent with the foreign judgment.
This is, in effect, a separate legal action to enforce the foreign court’s judgment as it pertains to the US pension asset.
Will this require legal expense? Absolutely. How much legal expense will be involved? That is difficult to say, and will no doubt vary, depending on the state, your client’s ability to find affordable yet competent representation, and perhaps also upon the degree of assistance your client (or you) can successfully elicit from the plan administrator.
It is understandable that the client may not be enthusiastic about going through the steps to attain a QDRO in the United States.
However, as noted above, there may be a better route to take.
Possible QDRO alternative: IRA Rollover
Is the client an active participant in the US pension, or is this a legacy pension from a prior US employer for which the client worked long ago while still residing in the United States?
Even where the client is still working for the plan sponsor and is an “active participant” in the US retirement plan, does the company provide for “in service distributions” that are eligible for rollover?
If either the client has separated from service to the plan sponsor or in-service distributions are allowed under the plan, the client should be eligible to roll over the current qualified plan vested account balance to an individual retirement account (IRA), which is NOT a qualified plan, and, therefore, is NOT subject to the ERISA non-alienability/QDRO rules.
Since ERISA QDRO rules do not apply to IRAs, the operative rules on the tax-free transfer of IRA assets are governed by specific provisions within the Internal Revenue Code (IRC) Section 408(d).
Section 408(d)(6) sets forth the requirements for such tax-free transfer of IRA assets incident to divorce:
• There must be a decree of divorce, or of separate maintenance, or a written instrument incident to such a decree; and
• There must be a transfer of an interest in an IRA to the spouse or former spouse.
Unlike the QDRO, there is no domestic court requirement here, and I see no reason for an IRA custodian to refuse to transfer assets in an IRA of the client to the IRA of the client’s former spouse, when furnished with a foreign divorce order calling for such division.
Nor do I see any reason why the IRS would refuse to find that a UK court order, and carefully executed IRA custodian-to-IRA custodian transfer, thereafter fails to satisfy the Section 408(d) requirements for a transfer incident to divorce.
So long as the UK court order is sufficiently specific in identifying the asset to be split and the split is handled carefully through transfer between IRA accounts after the UK court order is issued, a tax-free split of the IRA rollover should be feasible without the involvement of US courts.
Third option: His n hers
(Aka “What if the client is not eligible for a rollover of the US qualified (pension) plan.”)
If the US pension is not a majority position within the overall portfolio – and especially if it is of equal or lesser value than the UK pension – it might very well be worth considering an alternative property settlement that entails giving more, or all (depending on the circumstances) of the UK pension to the client’s spouse, while the client retains the US pension.
From a practical standpoint, so long as the UK divorce court agrees, this could be an effective way to resolve the division of property.
Moreover, since both the client and the spouse are US citizens and UK tax residents, it is unlikely (though possible in a lump-sum distribution election) that there would be disparate tax treatment of distributions from the US pension than distributions from the UK pension (per the US/UK income tax treaty, and the US savings clause therein).
Therefore, it should be reasonable to view the assets as having comparable tax characteristics, which would enhance the potential for this suggested alternative division, as an alternative to splitting each pension in an identical (50/50) manner.
Those are the three alternatives from which the US/UK dual national client may choose to accomplish the division of pension assets pursuant to this divorce.
Without knowing more about the financial situation of the couple and the characteristics of the US pension, it is hard to point out the best direction.
However, it should be clear now that rolling pension assets into a rollover IRA before attempting to divide this property, if possible, would be preferable, as it should eliminate the involvement of US courts from the process.
Whatever course is selected, make sure that the client works with the administrator or custodian, and follows the applicable rules (ERISA, IRC Sec. 408(d), or both) to ensure that the IRS characterises the division of retirement assets as “incident to divorce.”
Mistakes here could result in the client being taxed on the transfer of assets to the spouse as if it were a regular distribution (ordinary income tax on the amounts transferred, and, if the client is under 59 ½ years of age, a 10% penalty for early distribution).
For a larger pension, such a blunder could make the potential legal fees the client is resisting look like a tremendous bargain.
Thun Financial Advisors, LLC, located in Madison, Wisconsin, is regulated by the United States Securities and Exchange Commission, and provides fee-only financial planning and investment management services for its clients, most of whom are American expatriate families and other cross-border investors with investments held through US accounts.
The above article does not take into account the specific goals or requirements of individual users, and must not be relied upon in connection with any investment decision. Investors and their advisers should carefully consider the suitability of any strategies, along with an individual’s financial situation, prior to making any decisions on their clients’ behalf.
Readers who have technical and/or regulatory questions they would like Thun Financial Advisors or other experts in the area of expatriate advice to answer, on this website, are invited to contact Helen Burggraf at International Investment.