March 1, 2016
In January my newsletter focused on a little known strategy that allows alternate payees to withdraw money from a qualified retirement plan before normal retirement age without paying a penalty. This can be very helpful when cash is needed but the only place to get it is a 401(k) or 403(b).
Recently an attorney called me in just this situation: he has a client who needs cash after the divorce. Having read my newsletter, he thought tapping into the 401(k) would solve her problem. He called the 401(k) plan provider to find out what language to add to the QDRO, and was told not to change their QDRO template. That’s when he called me for help, and I realized I needed to write Part 2 of this topic: “How to Implement the Penalty-Free Withdrawal.”
To recap the January letter, normally when a distribution is taken from a retirement plan before the age of 59 ½ a 10% penalty tax is imposed by the IRS, on top of any normal income taxes. However the penalty is waived if the withdrawal is for an “alternate payee” (the spouse who is not the employee) from a “qualified plan” (a company retirement plan such as a 401(k)) and is pursuant to a divorce.
The implementation plan starts with the QDRO. There is nothing tricky about the language; the QDRO simply needs to contain language that instructs the plan provider to divide the 401(k) (I’ll use a 401(k) as an example but the plan applies to a 403(b) too.) The instructions should specify that a separate 401(k) account be set up for the alternate payee at the provider.
Once the alternate payee has a separate account, a request for withdrawal can be made for a fixed dollar amount, after which the remainder of the account can be left at the provider or rolled into an IRA at a new custodian.
Let’s look at an example: Stephanie, age 52, and Ralph, age 53, are divorcing. They own a house worth $500,000 and Ralph has a 401(k) worth $1,000,000. They agree on a 50-50 split so that they each will walk away with $750,000. But Ralph wants to keep the house, which Stephanie agrees to. So she’ll get $750,000 from Ralph’s 401(k) and Ralph will keep the house and $250,000 of his 401(k). Stephanie finds a condo for $200,000 and wants to put down $50,000, but she has no cash.
All she has is Ralph’s 401(k), so she tells her lawyer she’d like to withdraw $50,000.
A QDRO is written with instructions to split the 401(k) 75/25 and the custodian opens a new 401(k) account for Stephanie. Once her new account is funded, she submits paperwork to the custodian asking for a withdrawal of $62,500. When the custodian processes the withdrawal they will withhold 20% for income taxes and send her $50,000. They are not responsible for withholding the penalty – that would be assessed when Stephanie files her tax return and reports the withdrawal. Normally the IRS would see the withdrawal, see that Stephanie is not yet age 59 ½ and assess a 10% penalty. However Stephanie’s accountant completes Form 5329, “Additional Taxes on Qualified Plans”. By filling in code 06 on Line 2 she is telling the IRS that this is a qualified retirement plan distribution made to an alternate payee under a qualified domestic relations order, and is not subject to a penalty.
Once Stephanie has taken her withdrawal, which is allowed only once, she rolls her 401(k) to an IRA.