People getting divorced often need more cash than is readily available. There may be one-time expenses related to the transition, such as making a down payment on a new house or paying attorney’s fees. There also may be an ongoing need for more cash flow after the divorce than one’s salary, child support, and/or alimony can provide. The lack of ready money can delay or even aggravate the negotiations over the divorce settlement – which may only further reduce available cash.

Yet some divorcing couples have plenty of money – in the form of retirement assets -- which could solve these problems. In my practice as a certified divorce planner, I often find that people do not even consider using these assets for pre-retirement needs. There seems to be two reasons. The first is simple mind-set. People think retirement assets are only for retirement. And yet there is no objective reason why that must be the case. The second reason is more concrete. People believe – mistakenly -- that taking distributions from retirement assets prior to age 59 must result in a 10% penalty tax to Uncle Sam.

As it happens, there are at least four ways to access retirement savings prior to age 59 without being subject to the 10% penalty tax for early withdrawal. One method is available only to divorcing couples while the other three can be used by anyone. These methods can help some divorcing couples find a mutually agreeable settlement that would otherwise elude them.

What do I mean by retirement assets? Most IRAs (but not the Roth or Education IRAs) and “qualified” employer-sponsored defined contribution retirement plans. These include the 401(k), 403(b), money purchase, Keogh, SEP-IRA, SIMPLE IRA, and SAR-SEP plans. For the sake of simplicity, I’m going to use the term 401(k) in this article for all employer-sponsored plans.

I also want to be specific that these four methods avoid only the 10% penalty tax for early withdrawal. Money withdrawn from a retirement account is taxable the year it is withdrawn and there is no way around that.

The laws on retirement assets generally hold that withdrawing retirement assets prior to age 59 will result in a 10% penalty tax. For example, a 50-year-old who takes $20,000 from an IRA would pay a $2,000 penalty tax as well as the income taxes on the entire $20,000. Here are four ways to get the money while avoiding the penalty tax.

After discussing these 4 methods, I’ll address the wisdom of doing so.

Section 72(t) of the tax code states that the 10% penalty tax won’t apply to money taken from a retirement account if the money is withdrawn in “substantially equal periodic payments” (SEPP). Any IRA assets are eligible for Section 72(t). 401(k) assets are eligible only if the account owner no longer works for that employer; the 401(k) assets of the existing employer may not be used for this purpose.

The owner continues to direct the investments in the account that is being accessed under Section 72(t) just as they do in an IRA or 401(k) that is not being accessed. The owner does not need to use all of their IRA or 401(k) assets. For example, someone could have two IRAs: one is being used for SEPP to provide the income needed prior to retirement while the other is being deferred for use in retirement.

There are rules that must be followed to avoid the penalty tax and/or interest charges. First, the IRS has decreed that “periodic payments” means at least one payment per year. The owner could take monthly or quarterly payments if they wish but they must take at least one payment annually.

Second, the account owner must take payments for five years or until the owner is 59 , whichever period is longer. Once the longer period is over, the owner is free to change the payment amount or stop receiving payments altogether.

Third, the IRS offers three different methods of determining the “substantially equal” amount. Each method will produce a different amount and the owner may choose the method that is most favorable to their particular situation. The most important pitfall to avoid is setting the amount too high. If the Section 72(t) account fails to earn enough over the years to sustain the periodic payment, the account may run out of money thereby preventing the owner from complying with the duration requirement. That may result in taxes, penalties, and interest.

Suppose someone likes the idea of Section 72(t) but is concerned about managing the investment adequately so that they comply with the rules. There is an easy solution: purchase an immediate annuity. This method is available for IRA but not 401(k) assets. With an immediate annuity, an investor gives a lump sum of money to an insurance company in exchange for a guaranteed payment over a specified period of time. In most states, the annuitant can select a payment period that will last for a specific number of years or for as long as he or she lives, which meets the duration requirement. Insurance companies usually offer the choice of monthly, quarterly, semi-annual or annual payments, which solves the “periodic payment” requirement. Furthermore, the payment amount is fixed so the “substantially equal” requirement is met. The investment risk is transferred to the insurance company. Whether the market goes boom or bust, the company is contractually obligated to pay the annuitant the required payment.

Given all these advantages, why would anyone ever elect to use Section 72(t) instead of an immediate annuity? First, the periodic payment offered by the insurance company assumes a fairly conservative investment return. Moderate or aggressive investors who are comfortable with risk may feel that they could do better themselves. Second, people who purchase immediate annuities tend to outlive their life expectancy – so the insurance company uses adjusted life expectancy tables that result in smaller periodic payments for a given sum of money. Third, the exchange of a lump sum for the guarantee of a periodic payment is irrevocable. The annuitant cannot change his or her mind and get a refund.

With most employer retirement plans, money cannot be removed from the account while the employee still works there. A Qualified Domestic Relations Order (QDRO) as part of a divorce settlement is one of the few exceptions. Most of the time, a QDRO is used to transfer money from the 401(k) to the spouse’s IRA. Once in the IRA, the money is subject to all of the tax-deferral benefits and restrictions of any other traditional IRA.

However, the tax code also provides that money being transferred under a QDRO can go directly to the recipient spouse without being subject to the 10% penalty tax. These funds could then be used just as money in a savings account. Thus, this method can provide a lump sum of money that can be used for immediate purposes, such as a house down payment or paying legal fees. A QDRO does not have to be an all or nothing proposition. Some 401(k) money can be transferred to the spouse’s IRA while the rest is transferred directly to the spouse. Any funds that are transferred directly to the spouse cannot later be transferred into the spouse’s IRA (except for the $2,000 annual IRA contribution limit that applies to everyone.)

The QDRO method applies only to an employer-sponsored retirement plan but not to an IRA. Not all employer-sponsored retirement plans will qualify for this method. Some plans do not permit lump sum payments to anyone, even employees; some retirement plans fall under a different section of the tax code (e.g., the retirement plans of state and municipal governments may not be “qualified”). And it bears repeating that any funds transferred directly to the spouse become taxable income the year they are received. Generally, one should transfer to the spouse only the necessary amount and put the rest into the spouse’s IRA.

One of the exceptions to the age 59 rule applies to people who leave an employer after they have attained the age of 55. The tax code permits these people to begin taking distributions from a 401(k) without being subject to the 10% penalty tax for early withdrawal. The “separation from service” must be bona fide. The IRS has found, for example, that an employee who receives no compensation but who continues to work for the same employer has not separated from service.

In a divorce situation, however, a spouse may conclude that retiring or finding a new employer is a smart move if it enables them to begin taking distributions from their retirement plan. If they qualify for this method, the account owner can take as much or as little money from their account as they wish and they can use it for whatever purpose they wish. Whatever money they withdraw becomes taxable income, of course.

Which methods could be used will depend upon the needs and resources of the divorcing couple. Their need may be for a lump sum of money or it may be for a stream of income over time. The amount of money in IRAs and/or employer retirement plans also may dictate or restrict the best choice.

For most people who need a stream of income, the Section 72(t) and the Immediate Annuity Methods will be the only alternatives available. There are some pros and cons they may wish to consider.

Possible Exception to IRA - Lump Sum combination: There may be one opportunity to obtain, indirectly, a lump sum payment from an IRA. I have never seen this done but it appears to be feasible.

This could make sense if someone needs a lump sum and has significant assets in IRAs but few assets in 401(k)s.

Just because something is possible doesn’t mean one should do it. Generally, I encourage clients to keep their assets sheltered from taxes for as long as possible. Furthermore, using retirement assets to pay for non-retirement expenses begs the question: how are you going to pay for retirement?

It is increasingly common in a divorce situation, however, to find that the couple has relatively few liquid assets but significant retirement savings. This results in part from the American tradition of low savings coupled with high consumption, the forced saving nature of employer-sponsored retirement plans, and the significant appreciation of stocks in recent years. Anyone who has invested his or her retirement assets in stock mutual funds over the past 15 years is likely to have accumulated significant sums.

It makes no sense to ignore these assets as a potential solution to the problem of finding money for the immediate needs that can arise in divorce.  Nor does it make sense to raid retirement assets without evaluating the long-term consequences. If there is any way to meet a client’s need for an lump sum of money or an income stream without invading retirement assets, that way will usually be preferable to any of these four methods.

I recommend these methods only after a careful assessment of the client’s needs and resources. A comprehensive financial plan is in order whenever one’s financial or personal circumstances change significantly. Divorce certainly qualifies on both of those counts.