January 1, 2016
Normally, distributions made from a 401(k) or 403(b) or other qualified plans before the participant attains age 59-1/2 are called “early distributions” and are subject to income tax as well as a 10% penalty tax. That means a distribution taken could incur taxes equaling 50% or more depending on the individual’s federal and state tax bracket.
However there are a few exceptions where the penalty is not incurred: the penalty tax does not apply to early distributions due to death or disability, annuity payments for the life expectancy of the individual, or distributions made to an ex-spouse by a QDRO.
First let’s clarify the difference between “qualified plans” and other retirement accounts. A qualified plan is an employer-sponsored retirement plan that qualifies for special tax treatment under Section 401(a) of the Internal Revenue Code. The most common plans are 401(k)s and 403(b)s. IRAs (including Roth and SIMPLE IRAs) are not qualified plans.
The penalty exception gives a divorcing spouse a unique opportunity to access retirement money without a penalty. The tax Reg (72)(t)(2)(C) states that when you take money out of a qualified plan in accordance with a written divorce instrument (a QDRO), the recipient can spend any or all of it without paying the 10% penalty. The recipient still has to pay income taxes, but the penalty tax is waived.
Let’s take a look at an example of how this exception can be useful. There are some specific rules to be aware of. Here’s an example.
Sarah was married to an airline pilot who was nearing retirement. They were both age 55. There was $640,000 in his 401(k) and the retirement plan was prepared to transfer $320,000 to her IRA.
She could transfer the money to an IRA and pay no taxes on this amount until she withdraws funds from the IRA. But Sarah’s attorney’s fees were $60,000 and she needed another $20,000 to fix her roof. Because Sarah expressed her need for the money before the divorce was finalized, her attorney was able to include language in the QDRO that instructed the 401(k) plan administrator to make the withdrawal before transferring her half of the 401(k) to an IRA. Since the administrator withholds 20% to apply toward taxes on a withdrawal, Sarah asked for $100,000. After the 20% withholding, she had $80,000 in cash and $220,000 to transfer to her IRA. She was able to spend the $80,000 without incurring a 10% penalty on the $100,000, which saved her $10,000 in penalties.
After the money from a pension plan goes into an IRA, which is not considered a qualified plan, Sarah is held to the early withdrawal rule. If she says, “Oh I forgot, I need another $5,000 to buy a car,” it is too late. She will have to pay the 10% penalty and the taxes on that money.
When a divorcing spouse is under age 59 ½ this can be a very useful strategy since his or her access to retirement money is subject to the 10% penalty.
This is a great planning tool when clients have a need for cash and there is no other way to get it.