If you're married long enough, dividing retirement benefits in the event of divorce might seem like a real challenge. It's not actually that complicated, however. The most difficult part is usually determining what portion of your 401(k) is marital – only contributions made after the day of your wedding are subject to division in a divorce. After you've figured that out, a Qualified Domestic Relations Order should take care of any tax consequences when you divide the asset.
Qualified Domestic Relations Orders
A qualified domestic relations order – QDRO – is the document that transfers a portion of your 401(k) to your ex in accordance with the terms of your divorce decree. As long as you use one, there are no tax repercussions and the Internal Revenue Service doesn't treat the transaction as a withdrawal. QDROs are complex documents, but the task of creating one should not fall to you – you'll probably have to hire an attorney or accountant to draft one. Most plan administrators are exacting about the language that must be included in a QDRO, and the language is usually unique to each particular plan provider. You'll have to make sure your QDRO contains the correct wording so your plan provider will accept it, then have the divorce court judge sign it. When the QDRO is signed by the court, it allows your plan provider to transfer a portion of your 401(k) to your ex without penalties or taxes consequences.
Timing is critical if you want to avoid the tax consequences of transferring a portion of your 401(k) in a divorce settlement. You can't jump the gun and divide your plan early. If the transfer is made without a QDRO and before you've reached age 59½, the Internal Revenue Service will charge you a 10 percent penalty for the withdrawal. The plan provider must also withhold 20 percent to cover income taxes you'll owe on the money at the end of the year. Additionally, if your 401(k) increases in value during the year, you'll owe capital gains tax on that amount.
Effect of Changing Owners
After implementation of the QDRO and after the transfer, any tax issues associated with your ex's portion of your 401(k) become her problem. If she works for the same company you do, the provider will typically move her portion into another 401(k) in her sole name. Otherwise, the funds will roll over into an IRA in her name. In either case, the standard tax rules regarding early withdrawals apply to that account and to your ex, not you. If she makes an early withdrawal after the transfer, she's responsible for the consequences.
Cashing Out Vs. Rollovers
An exception exists regarding early withdrawal penalties if your ex decides to take the cash at the time of your divorce rather than roll over her portion into a retirement plan of her own. As long as your QDRO provides for the transfer and allows her to do this, neither of you would be subject to the 10 percent penalty if she cashes in rather than rolls over, assuming she does it immediately without reinvesting the funds.