401(k)s can provide a nice nest egg for retirement, and – subject to some tax rules and requirements – you can also dip into them if the unexpected occurs, such as a divorce. Employers typically create 401(k) retirement plans as employee benefits, and some employers match contributions made by their employees. These assets are groups of investments managed by professionals or sometimes even the employees themselves. They grow tax-free until withdrawal, and – at least to some extent – they're marital property.
If contributions have been made to your 401(k) by either you or your employer during your marriage, they will be considered marital property during divorce proceedings. Early withdrawals will be subject to standard taxes and will also be considered marital property.
Identifying Marital Assets
Contributions to your 401(k), both by you and by your employer, are marital property if they're made during your marriage. The same applies to interest and growth if it accrues between the date of your wedding and the time of your divorce. Contributions and growth pre-dating your wedding are yours and yours alone.
Therefore, if you're facing divorce and you take an early withdrawal, you face an additional problem besides the usual taxation and penalties. Your spouse is entitled to a portion of what you take out unless you spend it for the family's benefit. If you use the money for your own personal reasons, you must compensate your spouse for her share of the asset in the division of property as part of the divorce process.
Understanding Borrowing Vs. Withdrawal
Withdrawals from your 401(k) before age 59 1/2 are subject to a 10 percent early withdrawal penalty, and you'll have to include the withdrawal as income on your tax return. If the withdrawal occurs prior to your divorce, the owner – you – takes the full brunt of taxation and penalties. Another option might be to borrow against your 401(k) instead. Under federal law, you can take up to $50,000 and 50 percent of your vested balance, but you'll have to pay the loan back with interest over a five-year period. Otherwise, the early withdrawal penalty and taxes will still come due. There is an exception to this limit; if the account's balance is less than $10,000, you can borrow up to the full $10,000.
You'll also owe them if you change jobs before you pay off the loan. If you give any of the borrowed funds to your spouse pre-divorce, you'll have to include it in negotiations regarding overall property division.
Division in Divorce
It's usually better to wait until your divorce is final to break up your 401(k). Withdrawals made pursuant to a divorce decree or marital settlement agreement are penalty-free and sometimes tax-free. Your final decree typically orders a qualified domestic relations order – familiarly known as a QDRO – that directs your plan administrator to roll over your spouse's portion into an IRA in her name or to make a cash payment to her from your 401(k) balance.
Provided you make such a withdrawal pursuant to a QDRO, you won't owe any taxes or penalties. If your spouse takes the cash, she can do so without paying the 10 percent penalty, but she'll have to pay taxes on the money as income. She can't transfer it to another 401(k) in her name unless she also works for your employer.
Other Factors To Consider
Some plan administrators will not approve an early withdrawal without spousal consent if the plan owner is married. If you think your spouse might withdraw from her own 401(k) plan before your divorce is final, and if her plan allows it without your agreement, you might be able to take steps to prevent it. Your attorney may be able to freeze the account pending the divorce. At the very least and if she's successful, you should receive your share of the withdrawal's value in other assets or compensation at the time of your divorce.