401K in Divorce: A Tip That Can Save You Thousands
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 frequently come across is mishandling withdrawals from retirement accounts, particularly when it comes to dealing with a pre-tax 401(k) during a divorce. In this comprehensive blog post, we will delve into the intricate details of dividing a 401(k) in a divorce, unraveling the complex web of financial implications that are involved in such situations.
NOTE: I want to be clear that I'm not talking about any retirement accounts here. There is a lot of confusion when I'm talking with clients about types of retirement savings accounts. In this post, I am specifically referring to a pre-tax 401 k 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 401 k. If you are under age 59.5, this is an important tip you need to know about a 401 k in divorce. This only works if you are awarded all or part of your ex-spouse's 401 k. It does not work on your own retirement account.
Your Ex-Spouse's 401K
It's important to remember that the ownership of retirement accounts does not determine who will get what in the divorce settlement. Funds that were contributed during the marriage are marital property. Depending on your state, the earnings on pre-marital funds may also be marital property. Thus, determining the portion of the retirement savings account that will be distributed is generally considered after determining what portion of the account is marital. Of course, if it was opened and funded with money earned during the marriage, then the whole thing would be marital.
In order to divide a 401 k pursuant to a divorce, a Qualified Domestic Relations Order (QDRO) is filed with the plan administrator. When you file the QDRO, if you want to have all or part of your former spouse's 401 k 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to you, you have an opportunity to take cash out of the account without paying the IRS's 10% penalty (on funds withdrawn before age 59.5).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 401 k 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 could be subject to the early withdrawal penalty. You only avoid the penalty when the distribution is made directly from your former spouse's 401 k 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 funds are a good source of cash when going through a divorce? Let me be clear. No, I am not suggesting that at all. Generally, I discourage clients from cashing out their retirement accounts if at all possible, as it can push out your ability to retire by years. I simply want to share that if you have a cash need and it makes the most sense to take it from retirement savings, the IRS does allow you to take money from a 401 k without penalty.
However, if the funds are in a pre-tax account, they will still be taxable as ordinary income when withdrawn. The plan administrator is required to withhold 20% federal income 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. In addition, you may be subject to state taxes as well.
Should you cash out your 401k before divorce?
Remember 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 income 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 retirement accounts in your divorce will be based on your unique 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 financial advisor who holds the CDFA (Certified Divorce Financial Analyst) designation has specialized training in divorce financial planning and 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.
Based on my personal experience, I have observed that the execution of a Qualified Domestic Relations Order (QDRO) often tends to take longer than initially anticipated. Therefore, I always emphasize the importance of clients remaining proactive and vigilant throughout the process. By staying on top of the QDRO, any potential issues that may arise can be promptly addressed and resolved.
One of the most common challenges encountered during the QDRO process is when the non-participant spouse relocates, resulting in a mismatch between their new mailing address and the one on file with the plan administrator. This discrepancy in communication details can lead to missed correspondence, ultimately causing delays in the distribution of funds.
Therefore, it is crucial for both parties involved to ensure that all contact information is accurate and up-to-date to facilitate seamless communication and prevent any unnecessary setbacks. By taking these proactive measures, the QDRO process can progress smoothly and efficiently, leading to a timely distribution of funds.
Related post: Why You Need to Work with a Divorce Financial Advisor
About Intentional Divorce Solutions
At Intentional Divorce Solutions, we're committed to guiding individuals through the complexities of divorce with an approach centered on empowered choices and respectful outcomes. Our team provides comprehensive support and expertise in several key areas:
- Divorce Financial Planning and Analysis: Providing in-depth financial insights and strategies for a secure future post-divorce.
- Divorce Mediation: Facilitating respectful and balanced negotiations to reach mutually beneficial resolutions.
- Divorce Coaching: Offering personalized support and guidance to help you navigate through the emotional and practical challenges of divorce.
- Divorce Support Groups: Creating a space for sharing experiences and finding strength in community support.
Please Note: We focus on providing support and solutions in various aspects of divorce. However, we are not attorneys and do not offer legal advice.
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If you are on the journey of divorce and seeking professional, empathetic support, we are here to assist you. Reach out to us to discover how our services can be adapted to your unique needs, empowering you to make informed decisions for respectful and positive outcomes.
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