401K in Divorce: A Tip That Can Save You Thousands
401K in Divorce
Many expensive financial mistakes are commonly made when people are going through a divorce. It makes sense. Emotions are running high, and it's common not to want to engage a financial professional if you are already paying legal fees. That said, the cost of a financial professional relative to the amount they can save you in financial mistakes is minimal. One of the most common financial mistakes I see is how money is withdrawn from a traditional pre-tax 401K in a divorce. In this blog post, we will explore the intricacies of dividing a 401K in divorce and the financial implications involved.
NOTE: I want to be clear that I'm not talking about any retirement account here. There is a lot of confusion when I'm talking with clients about types of accounts. In this post, I am specifically referring to a pre-tax 401K account that is still held with an employer (not one that has been rolled into an IRA).
Unfortunately, going through a divorce leaves many people completely cash-strapped. While not ideal, if you have not built up enough liquid savings, you might consider withdrawing from a 401K. If you are under age 59.5, this 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 retirement account.
Your Spouse's 401K in Divorce
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to you, you have an opportunity to take cash out of the account without paying the IRS's 10% penalty (on funds withdrawn before age 59.5).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. It does not need to be the full amount that you are receiving. This is important, though. Don't roll it into an IRA first and then take it out because if you do, then you will be subject to the penalty. You only avoid the penalty when the distribution is made directly from your former spouse's 401K to you.
Related post: QDRO: I need a what??
Related post: Should I leave my Ex's retirement as is?
Financial Considerations: 401K Withdrawals and Tax Implications
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 from a 401K without penalty.
However, if the funds are in a pre-tax account, they will still be taxable when withdrawn. This is because the plan administrator will withhold taxes when the distribution is made. However, depending on your marginal tax rate, it may not be enough to cover your tax liability, so you'll want to plan accordingly.
Should you cash out your 401K before divorce?
Rember that withdrawals from a 401K before age 59.5 are subject to a 10% early withdrawal penalty. In addition, 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 the divorce is final and do it through a QDRO to avoid the 10% penalty.
How do I know how to best divide the 401K in my divorce?
The best way to divide accounts in your divorce will 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) with 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.
Dividing a 401K in Divorce: Understanding the Process
As mentioned previously, to divide a 401K, a Qualified Domestic Relations Order (QDRO) must be signed by the judge and filed with the 401K plan's administrator. Assuming the QDRO was drafted in accordance with the plan's requirements and the plan accepts it, it is then executed. That means the portion of the account awarded to the non-participant spouse is distributed per their directions.
In my experience, the execution of a QDRO always takes longer than expected. I always encourage clients to stay on top of these so that if any issues arise, they can be addressed right away. The most common problem is that the non-participant spouse moves, and the plan administrator does not have the correct mailing address on file for communication. Missed communications can delay the distribution of funds.
Related post: Why You Need to Work with a Divorce Financial Advisor
Here's how we can help you...
We get that divorce can feel really hard and leave you with a lot of questions about how to handle your finances. After all, this is the reason Leah Hadley founded Great Lakes Divorce Financial Solutions in the first place.
After her divorce, she found herself stressed and overwhelmed about navigating life on her own with three kids and a new financial situation.
Helping families overcome this challenge is why we do what we do.
Whether you've never had to manage money before or you're a master at investing, we are here to support you as your financial expert before, during, and after your divorce.
What our clients love most about working with us is that we're able to help them avoid costly financial mistakes and achieve the financial stability they need to plan for the future.
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