Retirement assets like employer-sponsored 401K accounts may be titled in one person’s name but be deemed shared assets in a divorce, thus requiring the divorcing couple to determine how to split the assets as part of their property division settlement.
Tax responsibility for distributions from a retirement account as well as the potential for incurring early withdrawal penalties should be evaluated when determining how to split a 401K account in a divorce.
401K distributions and taxes
As explained by the United States Department of Labor, a person who takes a distribution from their 401K account generally pays income tax on the money they receive, as the contributions are made with pre-tax dollars. Additionally, any distribution taken that does not meet retirement qualifications, such as a distribution taken prior to reaching age 59 years and six months, may also incur early withdrawal penalties.
Together, the taxes and penalties may significantly reduce the amount of money an account holder receives from their retirement savings.
The power of the QDRO
According to the Internal Revenue Service, a qualified domestic relations order allows a current spouse or a former spouse to be named as a legal payee on a person’s retirement account. Money may then flow directly to the former spouse as agreed upon by both parties from their divorce negotiations.
With the QDRO in effect, the account holder avoids the need to pay both income taxes and early withdrawal penalties on the distributions made to their former spouse. The recipient also avoids the early withdrawal penalties. Taxes may be avoided by the investment of the money into another retirement fund.