Things to know before you split 401(k) assets in divorce
Splitting 401(k) assets in a divorce can lead to unintended tax consequences, but there are ways to avoid financial penalties.
The tax rules for splitting retirement account assets in a divorce differ depending on the type of account — IRA, 401(k) or a pension — and can be complicated. Also, transferring retirement funds to a former spouse can have unintended tax consequences if done incorrectly, so the stakes are high for getting it right.
We’ll focus on splitting 401(k) accounts. A 10% fine hits many payouts before age 59½ from IRAs, 401(k) accounts and the like. This excise tax on early distributions is on top of regular income tax due. But paying 401(k) funds early to an ex-spouse can avoid the penalty — if done right.
The use of a qualified domestic relations order (QDRO) is needed. The QDRO, which is issued by a court or state agency, recognizes a divorcing spouse’s right to receive all or a portion of the account owner’s 401(k). There are two ways to divide plan assets using a QDRO. The first awards a separate interest in the account balance. The second allows a divorcing spouse to share in the payment of the benefits. Once both parties agree to the terms of the QDRO, the spouse who is the owner of the account gives the document to the plan administrator. Because drafting a QDRO can be expensive, see if your divorce attorney can ask the plan administrator to provide model QDRO language.
Here’s an example in which one spouse has a 401(k) worth $300,000 at the time of the divorce.
The divorcing couple could agree in the QDRO to split the account equally.
In that case, $150,000 of the 401(k) balance can be transferred directly to the other spouse’s traditional IRA without incurring any federal income taxes or penalties. That changes, however, if pursuant to the QDRO, the spouse receiving the $150,000 decides to pocket it instead of having it transferred to the IRA.
Then he or she will owe income taxes on the money, but there is no 10% penalty for early distributions, even if the spouse isn’t yet 59 ½.
The QDRO exception doesn’t apply to IRA funds paid to a spouse in a divorce. So the procedures for dividing an IRA in a divorce can be much more complex.