It is common to encounter a 401(k) account where the participant has taken a loan.
When that account needs to be divided in a divorce, it is important to know how the loan should be treated. If the parties agree to a dollar amount to be assigned to the former spouse, there is no need to address the loan. However, when a percentage is being assigned, the QDRO should include details that instruct the plan administrator how to make the calculation. The Alternate Payee’s share can be determined either before or after the loan is subtrnacted from the account.
Before the Loan is Subtracted
This option might be chosen when the Alternate payee is to receive a portion of the account as if the loan had not been taken. This could be in a situation where the loan was used to purchase something that the participant is being fully assigned in the divorce. For instance, if the total account is $100,000 with a $20,000 loan taken to purchase a car which is assigned to the participant in the divorce, then when assigning a portion of the account, the Alternate Payee’s share would likely be receive a share before the loan is subtracted.
To think of it another way, the total value is $100,000 and each party is to receive $50,000. If the $20,000 was used to buy a car assigned to the Participant, the remaining $80,000 should be divided with $50,000 going to the Alternate Payee and $30,000 going the Participant.
After the Loan is Subtracted
In a different scenario, the loan might have been used to procure an asset that is equally divided in the divorce. If the money was used to replace windows in the marital residence, which is then ordered to be sold and proceeds equally divided, the assignment to the Alternate Payee probably should be after the loan is subtracted. With our example, each party is entitled to $40,000 from the account and each would also share equally in the proceeds of the sale of the house.
A Third Option
If the loan was converted to an asset that is subsequently assigned to the Alternate Payee, a slightly different assignment may be required. If we go back to our car example but assume that the car is assigned to the wife, the result is different. The total is still $100,000 with each party needing to receive $50,000. Since the wife was assigned the car purchased with the loan, she would need to receive an additional $30,000 from the account. We know that including the loan (before subtracting) results in $50,000 and excluding (after subtracting) the loan results in $40,000. In order to get to the $30,000 a different approach is needed.
Our recommendation in this case would be to assign a lump sum dollar amount of $30,000. This does not require any calculation by the plan administrator and likely reduces the chance of misinterpretation or error in a calculation.
These simple examples are provided for illustration purposes only. One could accurately point out that the value of the hypothetical car in these examples is not $20,000 at the time of the division or the increase in value of the home is less that the actual cost of the windows. In most cases there will be complicating factors that should also be considered in some way.
The decision on how to treat a loan during the division of a 401(k), or any defined contribution plan, should normally, but not always, made based on what the loan was used for. If you are uncertain how the language of the Settlement Agreement should be prepared feel free to call us at (844) 721-6500. We would be glad to discuss the specifics of your case and either direct you to our recommended language in the Free Tools on our website (which by default excludes loans), or describe how we might prepare customized language to meet your specific requirements.