During divorce, one of the biggest financial considerations is the dividing of retirement accounts. 401(k)s are often a large portion of the assets being split and because of this I want to highlight the process of splitting 401(k)s and the tax considerations associated.
Legal process of splitting or dividing the 401(k):
Through legal proceedings, former spouses can be awarded funds from their previous spouses 401(k). This is done through a Qualified Domestic Relations Order (QDRO), a court decree that mandates how assets in a retirement plan will be divided in a divorce.
Tax ramifications on the 401(k) transfer to the former spouse:
- For the spouse losing/giving 401(k) assets: The transfer to the former spouse in non-taxable.
- For the spouse receiving the assets: If a QDRO is approved, the former spouse (receiver of 401(k)s funds) is typically given the option to keep the assets in the plan, roll over assets into an IRA tax-free, or they can take distributions. Distributions from a 401(k) pursuant to a QDRO are exempt from the 10% early withdrawal tax penalty. So, a former spouse that is under age 59.5 can take distributions from the account without paying a 10% early withdrawal penalty. The distributions will still be subject to federal and state income tax though.
401(k) to IRA rollover - major consideration:
- Once the QDRO is received by the former spouse, they can roll over this money to an IRA (tax-free transaction). But as soon as this happens, the former spouse loses the ability to avoid 10% early withdrawal tax penalties if they are under age 59.5!
- For spouses that are under age 59.5, there is a major tax advantage to leaving the assets in the 401(k) plan. As mentioned, the 10% early withdrawal penalty before age 59.5 is avoided if the assets are left in the 401(k). If the assets are moved to an IRA instead, the former spouse is now subject to the 10% early withdrawal penalty on those assets. The QDRO exception to the 10% penalty DOES NOT apply to IRAs.
Keep this in mind if you are going through this. As always, if you are going through a divorce, I recommend consulting with a divorce attorney to assist in the process.
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