Divorcing couples are often faced with the issue of having a large portion of their respective net worths in 401(k) Retirement Plans. These assets consist of tax-deferred investments which are taxable upon withdrawal and which often carry a 10% Tax Penalty if withdrawn prior to age 59 ½. With proper planning, exceptions in the Tax Code allow a divorcing couple to withdraw funds from the 401(k) Plan without the 10% penalty and can even to maintain the tax-deferred status of the investments.
A Qualified Domestic Relations Order (“QDRO”) as part of a divorce settlement is one of the exceptions. Historically, a QDRO has used to transfer money from the 401(k) Plan to the spouse’s IRA account. Once in the IRA, the money is subject to all of the tax-deferral benefits and restrictions of any other traditional IRA. A properly executed transfer does not result in taxation to either spouse, and there is no penalty for the withdrawal.
The tax code also allows money to be transferred pursuant to a QDRO directly to the recipient spouse (rather than an IRA) without being subject to the 10% penalty tax. These funds could then be used immediately to fund investments such as a house down-payment or expenses such as credit card debt or legal fees. Withdrawals from a 401(k) Plan can also be split between a taxable withdrawal for expenses and a non-taxable transfer to an IRA. However, any funds that are transferred directly to the spouse cannot later be transferred into the spouse’s IRA. Note, that any assets transferred directly to spouse from the 401(k), while exempt from the 10% penalty, will be taxed to the spouse in the year of receipt.
The QDRO exceptions apply only to employer-sponsored retirement plans and not to an IRA. The availability of a QDRO is determined by the Plan Agreement. Some plans do not permit lump-sum payments to anyone, even employees.
The rules dictated by the Internal Revenue Code and Regulations must be closely followed to receive the special tax treatment given to QDROs. Properly drafting is a must. You should seek the assistance of counsel experienced in drafting QDROs when considering distributions from a 401(k) pursuant to a divorce settlement.
Joseph W. Kenny is a director and shareholder of Hamblett & Kerrigan, P.A. and practices in the areas of estate planning and taxation. He is also a Certified Public Accountant with certification as a Personal Financial Specialist. You can reach Attorney Kenny by email at [email protected].