The Tax Consequences of 401(k) in a Divorce Settlement

Breaking up is always hard to do. But when it impacts your retirement savings, it can be downright painful, especially if you don’t have plenty of time to recover your losses. If you have a 401(k), the standard divorce 401(k) split could hit your retirement savings, with your spouse potentially getting as much as half. In fact, the top three most contentious items in divorces, ranked in order, are alimony, retirement accounts and business interests. But one of the costliest aspects of this could be the mandatory tax withholding that comes as a result.

401(k) Withdrawal Due to Divorce

A 401(k) plan is designed to remain in place until you reach retirement age, at which point you’ll begin taking distributions, and those withdrawals will be taxed as ordinary income. The minimum age to take distributions on a 401(k) account is 59½. So whatever tax bracket you’re in at the time will be the amount you pay. If you take the money out early, though, you’ll be subject to a 10 percent penalty, which could pull thousands of dollars from your earnings, depending on how much is in the account.

But there are exceptions to this penalty. One of those exceptions is when the early distribution is part of a divorce settlement. You’ll still each pay income tax on any amount that is withdrawn, but you won’t have to worry about the penalty. However, in order to divide your 401(k) without this penalty, you’ll need a Qualified Domestic Relations Order, which is issued by the court. The receiving spouse will also have to withdraw the funds properly to avoid the penalty.

Qualified Domestic Relations Orders

There are three steps involved in splitting a 401(k) during a divorce. First, the court will order the division to take place in the divorce decree. At that point, you and your attorney will draw up a QDRO, which describes to the plan administrator how it should be split to remain compliant with the Employee Retirement Income Security Act. The judge will sign off on the QDRO, as will the plan administrator, and at that point, the receiving spouse is known as the alternate payee.

The QDRO should contain the name and contact information of the plan participant and the receiving spouse. It will also name the retirement account(s) involved and the dollar amount or percentage to be paid out. There should also be a timeline for the payout and, if multiple payments will take place, when those payments should be made, as well as the amounts of each. It’s important that both attorneys are involved in approving the document to make sure it acts in the best interests of both parties.

Taxes and 401(k) Splits

To understand how the divorce 401(k) split works, tax-wise, it’s important to know your options as a separating couple. If the court orders half of your 401(k) to go to your spouse, he’ll likely want to roll the funds over into his own retirement account. As long as this is done via direct transfer, he’ll avoid the penalty.

If your spouse elects to leave the funds in your account until you retire, he’ll also avoid paying taxes until that time. You’ll both need to begin taking required minimum distributions by the time you reach 70½ to avoid paying a penalty. The final choice for the receiving spouse is simply to cash out his half and enjoy it now. According to IRS Code 72(t)(2)(C), if the cash-out is part of a QDRO, it won’t be subject to the 10 percent penalty. If you’re the receiving spouse, this is a great way to take the benefits now as opposed to rolling them over and saving them until later. However, you will be subject to income taxes on the amount, so use a 401(k) divorce calculator to determine exactly how much this option will cost before making that move.

Cash-Out Option

One important factor to consider if you’re thinking about taking the cash out option is that it’s a one-time deal. If the 401(k) divorce calculator doesn’t scare you off, you’ll need to act quickly if you want the money. Unless you’re over the age of 59½, you’ll pay the 10 percent penalty if you wait until later to cash it out.

Even if the court has issued a QDRO, it’s important that things be done in a timely manner. For a 401(k) withdrawal due to divorce to take place without penalties, the spouse that holds the 401(k) is responsible for submitting it to the plan administrator in a timely manner. If you’re the receiving spouse, the plan should get back to your spouse with a response in a matter of days. So if significant time passes and you’ve heard nothing, get in touch with your attorney for a follow-up. If a QDRO is in place, you have the right to contact the plan yourself as a prospective alternate payee and ask about your spouse’s benefits. If you get pushback, remind the representative that laws under the Department of Labor give you a right to this information.

In some cases, a 401(k) withdrawal due to divorce can be handled outside of the court system. You and your spouse could draw up an agreement that you’ll divide your 401(k) at the time of your retirement. If you and your spouse plan to leave the money in the account until you reach 59½, this could be a way to save time and avoid dealing with the rollover process now. It won’t, however, offer the clean break you may be hoping to have.

Splitting an IRA

If your retirement plan is an IRA instead of a 401(k), the process is called “transfer incident to divorce,” which is so similar to a QDRO, often courts will call it that unofficially. But when you submit your assets to the court, you’ll need to make sure you distinguish between different types of plans. As with a 401(k), the spouse holding the IRA will present the transfer incident documentation to the plan administrator to ensure the assets are divided properly.

Tax Law Changes

If you or your spouse is awarded alimony on Dec. 31, 2018 or later, changes in the tax laws will affect both spouses. Alimony is no longer tax-deductible under the new tax laws, and the receiving spouse will no longer have to claim income tax on the amount received. Attorneys are concerned that the changes may affect the ability to negotiate during divorce proceedings. The fact that alimony payments are tax deductible has helped offset some of the pain of agreeing to alimony. Attorneys fear the change may lead to fewer divorcing spouses agreeing to settle outside of the courtroom. If you’re looking into how a divorce 401(k) split may affect you, tax-wise, it may be worth investigating how this extra tax expense may hit you first.

If you’re filing taxes for the 2017 tax year, you likely used a 401(k) divorce calculator before taking the distribution in 2017. That amount is subject to taxes based on the brackets that were in effect in 2017. Since those have changed significantly under the Tax Cuts and Jobs Act, you’ll need to refer back to 2017’s information. If you’re single and you made $50,000 in 2017, including your post-divorce 401(k) distribution, you’ll owe $5,226.25 plus 25 percent of the amount over $37,950.