Crafting a smart divorce agreement<br> Providing spouses with penalty-free access to retirement funds
Sound divorce advice is particularly critical when it comes to splitting the retirement plans. This article shows how one or both spouses can avoid the 10% early withdrawal penalty.
Many spouses caught in the trauma of the divorce settlement process face the same problem. They have a need for cash but 100% of the savings is in retirement. One or both may have significant retirement accounts with their employer, but believe that these funds are not available to them without the IRS 10% penalty tax.
Most times, it is not sound financial planning to liquidate all or part of your retirement funds for purposes other than retirement; however, this may be the only source of cash available to maintain one’s standard of living.
Under a special section of the Internal Revenue Code (72(t)(2)(c), an alternative payee (i.e. the non-employee spouse) can take cash from a Qualified Plan (such as a 401k), without the 10% penalty, even if they are under age 59½. To avoid the penalty, the following criteria must be met:
- The retirement plan must be a qualified plan covered by ERISA (e.g. 401K and Defined Contribution Plans);
- The funds must be paid to an alternative payee, not the owner of the account; and
- A Qualified Domestic Relations Order (QDRO) must be created and used to divide the plan
The amount paid is taxable income to the alternate payee and the employer will withhold 20% of the distribution to prepay the tax. So whatever non-employee’s cash need is, the 20% withholding should be taken into account when asking for a withdrawal. If the spouse who is entitled to the distribution does not need all of the cash, part could be paid in cash and part could be transferred to that spouse’s IRA. There will not be a 10% early distribution penalty on the cash paid out or the transfer.
Let’s look at an example.
Fred and Ginger, age 45, are getting divorced. As part of the settlement agreement, Ginger is entitled to 50% of Fred’s 401K containing $400,000. Ginger needs cash of $100,000 to establish an emergency fund and pay some outstanding bills. Their attorney creates a QDRO that directs Fred’s employer to assign funds totaling $200,000 to Ginger. The Order further stipulates that Fred’s employer to pay Ginger $125,000 in cash, with $25,000 withheld to prepay the Federal income tax (note that Ginger may have to make a State Income Tax estimate also). The balance of $75,000 would be transferred to Ginger’s IRA.
In this transaction, Ginger would receive $100,000 in cash (and taxable income of $125,000) and $75,000 in her IRA, which is nontaxable. There would not be an IRS penalty for this withdrawal and transfer. It is very important to understand the rules of the retirement plan that is involved in this situation. The QDRO will not be effective unless its assignment of rights or division of benefits complies with the terms of the Plan.
One word of caution, this rule does not apply to IRAs. Any premature distribution related to a divorce would be subject to a 10% premature penalty.
What if both spouses needed cash?
This maneuver takes lawyering skill and creativity in drafting the agreement; however, the non-employee spouse could take more cash than needed and give the excess cash to the employee- spouse, possibly as a reimbursement of professional fees.
What if you only have an IRA?
Under code section 72, there is a penalty-free way to access your IRA if you are under age 59½.
In this example, John, age 53, needs additional income to make payments on a second mortgage recently obtained during his marriage. With support, it is extremely difficult to make ends meet. His only savings exists in his IRAs.
John can take a “series of substantially equal periodic payments” from his IRA. Distributions from such an arrangement are exempt from the ten percent penalty that normally applies to distributions taken before reaching age 59½. The flexibility in this arrangement is that the payments must continue for five years or until John reaches age 59½, whichever is later. After that period ends, John can stop taking the payments or take smaller payments. Extreme care must be used in setting up this plan as there are stipulations regarding interest rate assumptions, payment modifications, and investment changes.