When divorcing, many people realize that their hard-earned retirement savings must be split just like other assets as part of their property division agreement.
Spitting a 401K account during a divorce should be done with care so as to avoid paying excessive penalties that only further exacerbate the losses both spouses may experience.
401K distributions for non-retirement purposes
Given that a 401K account intends to provide an income to fund a person’s retirement living, any distributions from this type of account for any other reason may result in the assessment of early withdrawal penalties. These penalties may dramatically reduce the amount of money a person ultimately receives from their account. Even when a divorce decree stipulates one person should receive a portion of a spouse’s 401K account, these penalties may apply if the account owner takes a direct distribution and then provides that money to the former spouse.
The use of a qualified domestic relations order
The United States Department of Labor indicates that a qualified domestic relations order allows the spouse of a 401K account owner to be named as an authorized payee on the 401K account. Once the QDRO has been approved by the plan administrator, payments pursuant to a divorce settlement may flow directly to the authorized payee. These payments may avoid the assessment of early withdrawal fees, protecting the retirement assets from unnecessary losses.
Income taxes on QDRO distributions
A QDRO does prevent the assessment of early withdrawal fees but does not negate the need to pay income tax on any distributions. However, according to the Internal Revenue Service, an authorized payee may avoid immediate tax assessment on the funds by investing the money into another retirement account.
