Understand the Rules of Retirement Accounts in Divorce
Retirement accounts are a tax-related issue, but their complexity merits a separate category. Retirement accounts and a house are often the two most valuable assets a divorcing couple divides, so if a party finds that a large portion of his or her settlement consists of retirement assets, he or she needs to be aware of the many tax ramifications and potential penalties involved.
Normally, distributions from a retirement plan prior to age 59 1/2 are considered "early distributions" and are subject to a 10% penalty tax as well as ordinary income tax. An exception to this rule, however, is a transfer to an ex-spouse as part of a divorce settlement. A Qualified Domestic Relations Order (QDRO) is used to affect this transfer. Income taxes still apply, so any assets received from a "qualified plan", such as a 401(k), will be subject to a mandatory 20% tax withholding. For example, a party who is awarded a $100,000 distribution from an ex-spouse's 401(k) will actually receive only $80,000.
To avoid this mandatory withholding, the transfer must be made directly to another retirement account, such as an IRA. Once the assets are in the retirement account, they are subject to the early distribution rules.
To simplify, let's look at an actual example of how this transfer works:
Suppose John and Sally are divorcing at the age 55. John has $560,000 in his 401(k) that will be divided by a QDRO, transferring $280,000 to Sally. Sally can transfer the money directly to her IRA and pay no taxes until she starts withdrawing funds after age 59 1/2, at which time she would pay ordinary income tax on the amount. However, Sally needs $80,000 for a down payment on a new house, so she holds back $100,000 before transferring the remaining amount to her IRA. Of this, 20% is withheld for taxes, leaving her with $80,000 to spend without incurring a 10% penalty. After Sally transfers the remaining $180,000 to her IRA, she is held to the early withdrawal rule. To do this, Sally faces the 10% penalty and the taxes on that money.
IRAs are not qualified plans, so a QDRO is not needed to divide the assets. Also, there is no 20% mandatory tax withholding on a transfer. To avoid paying taxes, a party must deposit any distribution from an IRA directly to his or her IRA. If a check is sent, the money must be deposited into his or her IRA within 60 days to avoid a taxable distribution.
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