Funding a 401(k) is a gradual process. People often make contributions for years as a way of saving for retirement and reducing their taxable income. A 401(k) can be worth tens of thousands of dollars or more depending on the income of the person funding it and how long they have had the account.
Most professionals with 401(k)s know that there are penalties and tax consequences if they withdraw funds from the account before reaching retirement age. They may worry that their decision to divorce could diminish their resources when they retire later.
How can those preparing for divorce avoid the penalties and tax consequences associated with early 401(k) withdrawals?
By using special paperwork
Divorce is one of the rare scenarios in which people can withdraw funds from a 401(k) without necessarily triggering a penalty. The spouses have to work with a lawyer to draft a qualified domestic relations order (QDRO) after the courts approve a final property division order.
The QDRO must have the approval of both spouses and contain terms that reflect the final property division order. When submitted to the party managing the 401(k), the QDRO guides the process of dividing the account.
A percentage of the account balance goes toward the creation of a new account in the name of the other spouse. When properly performed, this process eliminates the income tax consequences and 10% penalty associated with premature account withdrawals.
By keeping the account whole
Property division statutes do not mandate the direct division of every asset. Instead, each spouse should receive an appropriate portion of the overall marital estate.
The spouses can potentially reach an arrangement in which one spouse keeps the 401(k) in consideration of other property division terms. Both marital debts and other high-value assets can serve to balance out the retention of a 401(k) during the property division process.
Either solution may help spouses avoid income tax obligations and penalties that will increase the financial challenges triggered by divorce. Reviewing the marital estate is an important first step for those expecting a complex property division process when they divorce. Retirement accounts are among the assets that can trigger conflict and require careful consideration during divorce negotiations.