IRA Rule Review #2: Avoid Messing Up a 401(k) Transfer Incident to Divorce or Separation

If you are a participant in an employer sponsored 401(k) (or similar) qualified retirement plan and you are under age 59½, a withdrawal you take from your account will be subject to a 10% early-withdrawal penalty unless an exception to the penalty applies. The penalty is imposed in order to discourage you from taking distributions before retirement.

Among the exceptions to the penalty tax are distributions due to the death of the account owner, distributions attributable to disability, distributions from a former employer’s plan after age 55, and distributions for deductible medical expenses.

One often overlooked exception applies to payment(s) received by an ex-spouse (the “recipient spouse”) pursuant to a qualified domestic relations order (QDRO) incident to a divorce or separate maintenance agreement. Under a QDRO arrangement, a portion of the payor spouse’s 401(k) is spun off into a separate account in the recipient spouse’s name. Thereafter, the recipient spouse may a) transfer their funds from the plan directly into their own IRA tax free; or b) take a taxable distribution of the funds from the plan without penalty.

Many recipient spouses fail to take advantage of the latter exception by rushing a transfer of the entire balance of their separate account from the plan into their IRA. Once the funds are transferred, subsequent IRA withdrawals are no longer protected from the pre-59½ early withdrawal penalty by the QDRO exception.

By rushing a transfer of the entire separate account balance into an IRA, the recipient spouse is wasting ability to keep some of those funds in hand to use for a down payment on a house, to pay down debt, or for other needs. While you will pay income tax on any funds retained, you will avoid the additional 10% penalty.

Plan before you act. You need to consider all of your financial needs before committing to a transfer of the entire balance of a separate account awarded in a divorce or separation agreement.