After a divorce, expenses start to pile up. You hire movers. You purchase new furniture and appliances. New service connection fees are collected by utilities and cable/internet providers. Apartments require security deposits and lenders for homes require down payments. Regardless whether you are staying in the home or not, the need for liquidity remains. Simply put, you need cash when you’re starting off.
For most couples, much of their net worth is tied up inside retirement accounts such as IRA’s and 401k’s. If this happens to be the case, it’s almost a certainty these funds will be accessed after the divorce to help pay the aforementioned expenses. Here’s the problem. If they’re not already 59 ½ years old, distributions from a retirement plan are usually subject to a 10% early withdrawal penalty. However, after a divorce, the spouse who is awarded all or a portion of a 401k plan can take a one-time withdrawal from the plan which is exempt from the 10% early withdrawal penalty. On the other hand, if you are awarded all or a portion of an IRA, distributions are NOT exempt from the 10% early withdrawal penalty. Let’s look at an example:
You are awarded half of a 401k in the divorce settlement, you then proceed to roll the 401k funds into your IRA and then request a withdrawal. You are now subject to ordinary income taxes plus the 10% early withdrawal penalty. The early withdrawal penalty exemption only applies to distributions from qualified plans (401k’s) not IRA’s. Take your penalty free withdrawal BEFORE transferring the 401k to an IRA.
It’s important to remember, the exemption from the 10% early withdrawal penalty is a ONE-TIME exemption and it has to come from a qualified plan, most commonly a 401k plan. Once the Qualified Domestic Relations Order (QDRO) has been approved by the plan administrator, a new account within the 401k plan is created for the benefit of the non-employee spouse. The plan administrator then transfers the amount awarded to the non-employee spouse as specified in the QDRO. At this point 100% of the assets awarded can be (1) distributed as cash to the non-employee spouse, (2) a portion distributed and the remainder transferred to an IRA or (3) all of it transferred to an IRA. The amount distributed as cash is taxed as ordinary income but not penalized. Here’s an often seen mistake and a few tips to help empower you to make the best financial decisions:
Planning Mistake: If you didn’t take enough out to cover your expenses, going back a 2nd time for more cash will cost you an additional 10% penalty. So, it’s important to accurately account for your cash needs when you take that first one-time penalty free withdrawal.
Empower Tip: If there are substantial assets in IRA’s, limited non-retirement assets and there’s a need for liquidity, consider transferring the IRA assets into a 401k before the divorce is final. This allows the IRA assets to be accessed once without the 10% penalty. Keep in mind, you cannot comingle a couple’s IRA’s or 401k’s. They must remain separate.
Empower Tip: If a 401k no longer exists due to a job or career change, it may be possible to open a Solo 401k to achieve the same outcome.
If your post-divorce expenses will require you to take funds out of a retirement account which will be subject to an additional 10% early withdrawal penalty, ensure this is accounted for in the settlement agreement. In many cases, this penalty can be minimized or avoided altogether with proper planning saving both parties money.
In the unfortunate event you or someone you know finds themselves facing divorce, or if you have questions regarding divorce and penalty free withdrawals, give me a call at (210)-EMPOWER. You can also hire a CDFA® to help you.
I hope this few tips help.
Chris, CDFA®, CFP®
CERTIFIED DIVORCE FINANCIAL ANALYST
Chris Powers is owner and advisor of Empower Wealth Advisors in San Antonio, TX. He has been a financial advisor for 18 years. If you have any questions or would like to learn more visit Empower Wealth Advisors website: www.EmpowerWealthAdvisors.com or call (210)-EMPOWER.