People who get divorced often have 401(k) retirement plans. The funds in a 401(k) plan are “qualified” funds. This means that the income tax on these funds, and income tax on the interest or gain realized by these funds, has not yet been paid. The income tax is paid later, as the funds are withdrawn from the account. The withdrawal usually occurs after retirement, when the person taking the funds is in a lower tax bracket.
Typically, funds cannot be removed from a 401(k) plan prior to retirement. Employers often give loans which are secured by 401(k) plans, but these are loans. It is not a withdrawal from the plan.
At divorce, the assets in a 401(k) plan can be allocated between the parties. The court does this with an order called a “Qualified Domestic Relations Order.” While language in a QDRO can be included in the divorce Judgment and Decree, usually it is contained in a separate order, entered after the Judgment and Decree is entered. This is not a requirement, but it is common practice.
A QDRO is essentially an order that tells the plan administrator to establish a new account in the name of the non-participating spouse. The QDRO tells the plan administrator to transfer an amount of money into the name of the non-participating spouse (that is, the spouse who does not work for that employer).
Usually, the non-participating spouse can direct that his or her portion of the 401(k) asset be rolled over into an Individual Retirement Account. This is a non-taxable event. Again, the tax will be paid when the money is withdrawn, usually during retirement.
However, often a person will withdraw funds from an IRA before retirement. This is a taxable event, and it is also subject to a penalty. In addition to paying federal and state income taxes, the spouse also pays a 10% penalty. Depending on one’s tax bracket, almost half of the IRA withdrawal could be paid to the Internal Revenue Service and the MN Department of Revenue in taxes or penalties. So, this is not a particuarly good deal.
There is a little know provision of the Internal Revenue Code that allows the party receiving the transfer of some of the 401(k) asset to withdraw cash without paying the 10% penalty. The withdrawal has to be made within 60 days of the divorce, and there has to be a financial emergency. Of course, the income tax on the withdrawal does have to be paid. That cannot be avoided. But, with proper drafting, the 10% penalty can be avoided.