Retirement plans such as 401(k)s and IRAs can be divided between spouses in divorce. However, the division must be done carefully to avoid immediate taxation, the 10% early withdrawal penalty, and in the case of qualified plans, disqualifying the entire plan because plan rules generally provide that the participant’s plan benefits cannot be assigned to another person.
Dividing Qualified Plans
The tax law allows an assignment of qualified retirement plan benefits to the non-participant spouse if the assignment is made pursuant to a qualified domestic relations order (QDRO).
If the assignment is made through a QDRO, the following tax consequences are realized:
- No tax liability is incurred because of the division
- Alternate Spouse is Taxed on Distributions: The alternate spouse is the person who receives the assignment of the qualified plan benefits formerly belonging to the employee participant. If the alternate payee is someone other than a spouse (e.g., a child), the plan participant is taxed on the distribution.
- The 10% Penalty Does Not Apply: the 10% early withdrawal penalty does not apply to a distribution made under a QDRO.
- Rollover Treatment is Allowed: if the alternate payee is the spouse or former spouse of the plan participant, any distribution received by the alternate payee will qualify for rollover treatment in the same manner as it would have had the plan participant received the distribution
- Participant’s Basis is Allocated: if the plan participant has basis in the qualified plan, the basis amount is divided pro-rata based on the amount transferred to the alternate payee and the total amount of the plan balance.
Example: Tim and Laura get divorced. Laura has a $100,000 in a 401(k) account. The divorce decree divides Laura’s 401(k) account 50/50 between them. The division is made pursuant to a QDRO.
The division has the following consequences:
- Neither Tim nor Laura are taxed on the $50,000 401(k) balance transfer.
- When Tim takes a distribution from his newly acquired 401(k), he will be taxed on the distribution
- Tim will not be liable for the 10% withdrawal penalty if he is under 59 and a half years old
- Tim can rollover a distribution from the 401(k) to another plan. However, if Tim rolls over a distribution into an IRA, any subsequent distribution from the IRA will be subject to the 10% early withdrawal penalty if Tim is under 59 and a half years old when he takes the distribution from the IRA.
So What is a QDRO?
A QDRO is a judgment, decree, or order that meets the following requirements:
- it provides for child support, alimony payments, or marital property rights for a spouse, former spouse, child, or other dependent of a qualified plan participant and is made pursuant to a state domestic relations law
- it creates or recognizes the right of the alternate payee to receive all or a portion of a participant’s benefits under a qualified retirement plan.
It specifies the following:
- the name and last known mailing address of the participant and each alternate payee
- the amount or percentage of the participant’s benefits to be paid to each alternate payee
- the number of payments or periods to which the order relates
- each qualified plan to which the order applies
The IRS is a bit of a stickler when it comes to requiring this information in QDROs. If any of the above information is not in the QDRO, the IRS may argue that the division is a taxable distribution from the participant’s qualified plan. This would result in immediate taxation to the plan participant, the 10% penalty, and may jeopardize the entire qualified plan because benefits were assigned to a non-participant.
IRAs are Different
The rules regarding QDROs do not apply to the division of IRAs. However, the transfer of an individual’s interest in an IRA to a spouse or former spouse under a divorce or separation agreement should not be a taxable event to either spouse.
To receive tax-free treatment, it is critical that the divorce decree specifically require the transfer. It is also very important that the IRA funds be transferred DIRECTLY to the other spouse’s IRA and not first distributed to the spouse who originally owned the IRA. If the IRA owner takes a distribution from the IRA and then transfers the funds into his former spouse’s IRA, he will have taken a taxable distribution from the IRA and could be subject to the 10% early withdrawal penalty.
Once the IRA balance is transferred to the new owner, the new owner will be subject to the 10% early withdrawal penalty if he/she takes a distribution out of the IRA before age 59 and a half. This is different from the rule regarding distributions from qualified plans divided under a QDRO, where the alternate payee’s distributions are not subject to the 10% penalty.
If you have any questions on how this applies to you, please feel free to give us a call.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.