Unfortunately, going through a divorce leads many people completely cash-strapped. While not ideal, if you have not built up enough liquid savings, you might be considering a withdrawal from a 401K. Here is an important tip you need to know about a 401K in divorce. This only works if you are awarded all or part of your spouse's 401K. It does not work on your own.
When you file the Qualified Domestic Relations Order (QDRO) to have all or part of your former spouse’s 401K distributed to you, you have an opportunity to take cash out of the account without paying the IRS’s 10% penalty (on funds withdrawn before age 59.5). To take advantage of this, when dividing a 401K in divorce, have the portion you need, paid directly from the account to you.
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It does not need to be the full amount that you are receiving. Do not roll it into an IRA and then take it out because then you will be subject to the penalty.
Am I suggesting that retirement plans are a good source of cash when going through a divorce? Let me be clear. No, I am not suggesting that at all. I simply want to share that if you have a cash need and it makes the most sense to take it from a retirement account, the IRS does allow you to take money without penalty.
Keep in mind, though, if the funds are in a pre-tax account, they will still be taxable when withdrawn. The plan administrator will withhold taxes when the distribution is made. However, it may not be enough to cover your tax liability, depending on your marginal tax rate, so you’ll want to plan accordingly.
Rember that withdrawals from a 401K prior to age 59.5 are subject to a 10% early withdrawal penalty. The withdrawal will be reported as income on your tax return. If the withdrawal happens before the divorce is final, the owner is responsible for the taxes and penalties unless you negotiate otherwise. If you are cashing out a portion of the 401K for the non-owner spouse, wait until after the divorce is final and do it through a QDRO so you can avoid the 10% penalty.
The best way to divide accounts in your divorce is going to be based on your financial situation. There is no one-size-fits-all approach. It is best to consult with your financial advisor and/or tax professional to determine what is in your best interest. A CDFA (Certified Divorce Financial Analyst), who has specialized training in divorce financial planning can be especially helpful. A CDFA can help you make the right decisions when dividing your 401K and other assets in a divorce.
For questions or assistance with a 401K and divorce or accessing the best source of cash for your particular situation, schedule a strategy session.
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