There are many expensive financial mistakes that 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 One of the most common financial mistakes I see is how money is withdrawn from a traditional pre-tax 401K in a divorce.
NOTE: I want to be clear that I'm not talking about just 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 be considering a withdrawal 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.
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to you, you have an opportunity to take cash out of the account without paying the IRS’s 10% penalty (on funds withdrawn before age 59.5).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 directly.
Related post: QDRO: I need a what??
Related post: Should I leave my Ex's retirement as is?
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.
Keep in mind, though, if the funds are in a pre-tax account, they will still be taxable when withdrawn.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.
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 how to navigate 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.
We are here to help you with that, too. Learn more about our guidance no matter where you are in the divorce process.
Then, schedule a complimentary consultation to explore how we can support you.