There are a few circumstances where you won’t get penalized for touching your 401K retirement plan early and divorce is one of them. A 401K retirement plan is considered an asset and, in a divorce, you’ll have to figure out what spouse gets what asset (or if they are evenly split down the middle).
Splitting retirement plans and assets can be an added headache and stress in an already emotionally draining divorce case. In some cases, a 401K retirement plan is a divorcing couple’s biggest asset.
If the division of these assets isn’t done by a knowledgeable divorce attorney, then both parties can expect expensive taxes, harsh penalties and more money than intended going to an ex-spouse.
How A 401K Retirement Plan Is Split During A Divorce
Splitting a 401K retirement plan happens in three steps. First, a divorcee decree is ordered for the division since it’s one of the qualifying circumstances for early withdrawal with no penalties. A divorce lawyer will need to draw up a domestic relations order that is a legal document referred to as a QDRO.
This document explains to the administrator of your retirement plan that it must divide the 401K so that it complies with the Employee Retirement Income Security Act. Then a judge will need to approve and sign the QDRO order before the 401K administrator signs off on the division of the asset. What the QDO does is establish your ex-spouse as an “alternate payee,” which makes them another person to receive payment from the plan.
Transfer Incident To Divorce Versus QDRO
Proper handling of your assets in a divorce is important, ensuring that the right person will pay for any applicable taxes. The type of retirement plan you will split will determine the rules that you’ll have to follow.
Even if you and your ex-spouse will divide your IRAs and any qualified plans in the same manner, there’s a separate legal term that applies to the type of division you use. IRAs are different from 401k plans and are divided using a transfer incident to divorce rather than a QDRO.
Some courts label both types of assets as QDROs, but you’ll need to clearly choose the category of which your asset falls into when submitting the information to the judge so that it’s listed right in the divorce agreement.
If you don’t, you’ll end up running into unnecessary complications that could be costly. Because things can get confusing, it’s usually best to hire a financial expert to help with the division of assets, especially IRAs and 401k retirement plans.
How A 401k Retirement Plan Is Distributed
There are three options for your ex-spouse to choose from when it comes to the distribution payments of your 401k plan. First, the QDRO must explain the method that they choose, and the plan administrator will then begin the distribution process.
First, they can roll over their portion of your 401k into their own retirement plan or simply leave their share with yours in the existing retirement plan. They’ll then take their portion, or payments, when you retire, too. Or, they can choose to accept the money as a cash payment when the divorce is finalized.
There are penalties associated with a lump sum withdrawal from a retirement account after a divorce. If your ex-spouse is under the age of 59 ½ and wants the cash, that payment will most likely get hit with a 10% withdrawal penalty.
Plus, they’ll have to report that payment to the IRS so that it’s taxed and if that lump sum of cash is very large, it can even be taxed in a higher tax bracket.
What You Should Do To Protect Your 401k
If you’re getting divorced or even considering it, you’ll want to make sure that you get your finances in order now about how you want your retirement plans to be divided. You’ll want to better understand the general rules of how your plans work and what will happen when they are split.
Also, not that there are different laws and rules related to the division of retirement and pension assets depending on what state you live in. You’ll need to do your homework to find out what rules your state has about the matter.
You’ll also want to get a professional divorce attorney to represent you. Even if dividing the other assets, you have seemed straightforward, it’s better to have a skilled divorce lawyer on your side to review the division of all pension and retirement assets. If you’re uneducated on this matter, you’ll lose a lot of money in the long run.
If you and your ex-spouse can’t agree on the division of assets, then you’ll need to involve the legal system to decide on the split, which will be declared by the court. But there are other methods to use for divorce proceedings, such as mediation or collaborative proceeding.
These two methods allow you to take control back so that you and your ex-spouse can decide on the terms of the split instead of the court. The courts will make their decision on the subject of your asset division based on a variety of factors as well as the laws of the state in which you live.
Other factors are how much you both made during your marriage and the contributions and roles played by both parties throughout the marriage.