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Investment Planning |
Splitting 401(k)s and IRAs in a divorce
Divorce affects over two million people a year in the U.S. If you're getting divorced and are splitting up assets, keep these pointers in mind to discuss with your attorney and/or financial advisor.
In some circumstances, a 401(k) can be split between the divorcing couple and the non-employee spouse can get her own account with the employee spouse's company. If this happens, the non-employee spouse will be subjectto the normal rules of a tax-deferred retirement plan for payouts: Begin withdrawals penalty-free at age 59 1/2, but withdrawals must start by age 70 1/2 at the latest, to avoid penalties.
If instead you decide to withdraw money from the retirement plan for the non-employee spouse, make sure that you have a Qualified Domestic Relations Order (QDRO). A QDRO is a court order issued as part of a divorce. It tells the Plan Administrator of a pension or retirement plan what amount is to be given to the non-employee spouse when the couple's assets are split. Be careful if you're getting divorced and you expect to split a retirement plan with your ex -- if you withdraw the money from your retirement plan before the QDRO is approved, you'll pay income tax and penalties on the withdrawal. An IRA is not considered a qualified retirement plan. When dividing an IRA between two divorcing individuals, you don't need a QDRO.
Here's an example. Jane and Billy are getting divorced. Jane has stayed home with the kids for 10 years and has no retirement plan. The QDRO issued as part of the divorce states that Billy must give Jane half of his $100,000 401(k) plan, or $50,000. If Billy just withdraws the $50,000 from his plan and gives it to Jane, Jane will receive only $40,000, since the plan will withdraw 20 percent for taxes. Billy will then have to declare the $50,000 as taxable income, plus he'll have to pay early withdrawal penalties on this sum. Instead, Billy should wait for the finalized QDRO. Billy can withdraw the entire $50,000, tax-free, and Jane will pay tax on the withdrawal, but no penalties.
A QDRO does not apply to an IRA. The trustee of the IRA may need to see a divorce decree before the IRA is split. The non-employee can roll over the assets to her own IRA, and there will be no withholding for taxes nor any penalties as long as the trustee knows the transfer is being done as part of a divorce. The assets in the new IRA can be invested, tax deferred, as the non-employee chooses. She won't pay tax on the money until she withdraws it after she turns age 59 1/2 and no later than her age 70 1/2.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.