The millions of Americans who live and work outside of the United States face unique and challenging planning issues due in large part to their native land's unique tax policies on citizenship-based tax residency and the many special tax and reporting provisions pertaining to foreign financial assets.
Such complications are also present when expat marriages end in divorce, and the expat couple may face additional burdens when dividing wealth spread across borders — especially American tax-advantaged retirement plans like 401(k)s, which are often subject to special rules when divided pursuant to a divorce decree or martial property settlement. Divorcing abroad naturally means working within a legal system that is unfamiliar with those rules. Therefore, it is incumbent on the divorcing expat to become familiar with these rules and explore options well ahead of the final divorce decree.
Under ERISA, the federal employment law that preempts state law, an employer-based plan administrator may not split a participant's (that is, an account holder's) funds and distribute ownership to a divorcing spouse without a qualified domestic relations order (QDRO). A QDRO must be a state court judgment, decree or order relating to child support, spousal maintenance or marital property rights. The couple divorcing abroad would need a separate U.S. state court proceeding to enforce a foreign court's judgment as it pertains to U.S. qualified retirement plan assets.
Launching a legal proceeding in a second country, however limited, is not ideal. Fortunately, there may be a better method: a rollover of the U.S. plan's assets to an individual retirement account (IRA), which is not a qualified plan subject to ERISA's QDRO requirements. If a) the account owner has separated from service to the plan sponsor or b) in-service distributions are allowed under the plan, the vested or eligible balance can be rolled over to an IRA.
Post-rollover, the operative rules on the subsequent division of IRA assets are governed by the Internal Revenue Code (IRC), Section 408(d)(6) on transfer of property incident to divorce:
• There must be a court order of divorce or separation, 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 no reason for an IRA custodian to refuse to transfer assets from the IRA of one divorcing party to the IRA of an ex-spouse pursuant to a valid divorce. As long as the foreign court order is sufficiently specific in identifying the asset to be divided and the division is handled consistently with that court order, a tax-free transfer of assets between IRAs should be feasible without the involvement of U.S. courts and still satisfy the IRC Section 408(d)(6) requirements.
The actual challenge may be in establishing IRAs for the divorcing couple. In recent years, U.S. financial institutions have begun to close their doors to residents of foreign countries – even those foreign residents who are U.S. citizens. If the couple is unable to open IRA accounts as a precursor to the property settlement, they may want to seek the assistance of an experienced financial planner who works with American expats. To ensure a proper transfer, this account positioning should be done in front of any final property settlement agreement and/or court decree dividing the U.S. retirement assets.
In the event that the U.S. retirement plan is NOT eligible for a rollover, the divorcing couple will have a decision to make:
• Start an ancillary state court action to obtain a valid QDRO; or
• Creatively effectuate a property division that leaves the U.S. retirement plan account solely to the plan participant spouse.
However, in this cross-border environment, where the divorcing parties are subject to potentially multiple tax jurisdictions, a reasonable property division should require a careful after-tax analysis, acknowledging the tax implications for each asset in each country and any relevant tax treaty relief.
Whatever the chosen course, the U.S. account holder should work closely with the plan administrator and/or the IRA custodian, and follow the applicable rules (ERISA, IRC Sec. 408(d), or both) to ensure that the IRS deems the division of retirement assets as "incident to divorce." Mistakes here could result in the account holder (not the recipient ex-spouse) being taxed on the transfer of assets as if it were a regular distribution (i.e., as ordinary income, with a 10% penalty if the plan participant is under age 59½).
R. Stanton Farmer is a financial adviser at Thun Financial Advisors.