If you have been reading these newsletters, you should now have a pretty good idea of what a defined contribution plan is all about. It can most easily be equated to a tax-deferred savings account. While the concept is not hard to grasp determining what portion of the account is marital property can be.

If the plan participant joined the plan (often a different date than the date of employment) after the date of the marriage it is relatively easy to assign a value to the marital property component. In that scenario each party to the divorce would be entitled to one half of the account balance on the marital property accrual cut-off date. The non-participant spouse would also be entitled to all interest, dividends, gains or losses that are attributable to his or her portion between the marital property cut-off date and the date the funds are actually distributed to them. Unless there are substantial other marital assets to offset the non-participant’s share, defined contribution plan funds are usually distributed with a Qualified Domestic Relations Order.

This is a tax-free transfer to the participant and if a trustee to trustee transfer is made to another tax deferred retirement account (IRA, etc.), it is also tax free to the non-participant. Upon receipt and approval of a Qualified Domestic Relations Order, most plans will pay out the non-participant spouse’s share immediately. If he or she elects to receive the money directly (no transfer to an IRA or other tax deferred retirement account) then the amount received must be added to their income in the year of receipt and all taxes incurred must be paid. The plan will automatically withhold 20% of the proceeds and pay it to the IRS in the name of the payee. In the case of direct payment to the non-participant spouse, the 10% early withdrawal penalty due on receipt of certain lump sum retirement accounts before age 59½ would be waived. This is an exception written into the federal tax laws specifically to facilitate marital breakup property distributions.

The difficulty in identifying the marital portion of a defined contribution account arises when the participant is already in the plan when he or she marries. Most states treat the funds in the account on the date of marriage, plus all passive earnings on that portion of the account, as the separate property of the participant. There are two ways that the value of the separate property on the marital property cut-off date can be identified for distribution purposes - the easy way and the hard way.

The easiest way to apportion the account value at the time of the marital breakup is to do a time value coverture calculation. If a participant began contributing to the plan on January 1, 1985, got married on January 1, 1990 and the marriage broke up on January 1, 2004, then the coverture calculation would be applied by simply dividing the fourteen years that the parties were married by the nineteen years the participant was in the plan and identifying the marital portion as 73.6842% of the account balance on the marital property cut-off date. The non-participant spouse would be entitled to one half of that or 36.8421% of the account on that date plus any post appraisal date earnings or losses on his or her portion. If the earnings and growth of the plan had been fairly consistent throughout the duration of plan participation this method would result in a distribution that should be deemed equitable by all parties. Comparing the outcome of this method with others usually results in less than meaningful differences.

If the earnings and growth during the marital period had been extremely erratic and one party or the other insists on apportioning the asset based on the actual passive growth on the participant’s separate property share, then you are faced with a difficult, often expensive, and sometimes impossible, task. The account must be analyzed in detail to determine the value of the participant’s separate property with the goal of identifying the specific worth of that portion of the account on the marital property cut-off date and then bring it up to its actual value on a date close to the date a report of this analysis is prepared.

This report will require the services of a third party consultant who will analyze the growth, usually on a quarterly basis, throughout the marital period to ascertain the actual value of the non-marital portion of the account. The consultant’s starting point is the value of the account on the date of the marriage. As many plans have options wherein the participant can allocate their funds to different investment vehicles, and optionally change them at will, this can be a very difficult and time consuming exercise. Also, as mergers and acquisitions have not been uncommon during the past 25 years, just getting the necessary information from the employer can sometimes be impossible.

To perform the kind of analysis that will satisfy all concerned it is necessary to have all the quarterly investment reports provided to the participant during the marital period available. If you are talking about a fourteen year marriage, unless the participant saved every quarterly statement, getting the necessary information will usually be impossible. If some statements have been retained you can get close as long as two consecutive statements are not missing. But if two or more consecutive statements are missing, you force the analyst to move from science to art and the results can easily be challenged.

More often than not, retirement plan managers won’t provide duplicate statements that have already been provided once to the participant. They, rightly, cite the uncompensated expense of digging up old records. This is a particular problem if the period in question is lengthy and the company has changed ownership or investment plan managers a couple of times. If that is the situation then the parties will either have to use the coverture method or come to agreement as far as a settlement figure. In the absence of evidence, it is doubtful that the cost of litigating the issue before a judge will produce a satisfactory result. In all likelihood the judge will fall back on the coverture method as the only way to come to equity.

You should explain this to your client and hope that reason prevails. While it is true there was spectacular growth during the mid-nineties there has also been spectacular losses since 2000. It really tends to even things out and makes the coverture methodology still a realistic approach to valuing defined contribution plans.