What to Know Before Splitting 401(k) Assets in a Divorce: The Tax Letter

Splitting 401(k) assets in a divorce can lead to unintended tax consequences, there are ways to avoid financial penalties.

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Getting the right tax advice and tips is vital in the complex tax world we live in. The Kiplinger Tax Letter helps you stay right on the money with the latest news and forecasts, with insight from our highly experienced team (Get a free issue of The Kiplinger Tax Letter or subscribe). You can only get the full array of advice by subscribing to the Tax Letter, but we will regularly feature snippets from it online, and here is one of those samples…

The tax rules for splitting retirement account assets in a divorce differ depending on the type of account—IRA, 401(k) or a pension—and can be complicated. Also, transferring retirement funds to a former spouse can have unintended tax consequences if done incorrectly, so the stakes are high for getting it right. 

We'll focus here on splitting 401(k) accounts. A 10% fine hits many pre-age-59½ payouts from IRAs, 401(k)s and the like. This excise tax on early distributions is in addition to any regular income tax due. But paying 401(k) funds early to an ex-spouse can avoid the penalty…if done right. 

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The use of a qualified domestic relations order (QDRO) is needed. The QDRO, which is issued by a court or state agency, recognizes a divorcing spouse’s right to receive all or a portion of the account owner’s 401(k). There are two ways to divide plan assets using a QDRO. The first awards a separate interest in the account balance. The second allows a divorcing spouse to share in the payment of the benefits. Once both parties agree to the terms of the QDRO, the spouse who is the owner of the account gives the document to the plan administrator. Because drafting a QDRO can be expensive, see if your divorce attorney can ask the plan administrator to provide model QDRO language.

Here's an example in which one spouse has a 401(k) worth $300,000 at the time of the divorce. The divorcing couple could agree in the QDRO to split the account equally. In that case, $150,000 of the 401(k) balance can be transferred directly to the other spouse's traditional IRA without incurring any federal income taxes or penalties. That changes, however, if pursuant to the QDRO, the spouse receiving the $150,000 decides to pocket it instead of having it transferred to the IRA. Then he or she will owe income taxes on the money, but there is no 10% penalty for early distributions, even if the spouse isn't yet 59 1/2. 

The QDRO exception doesn’t apply to IRA funds paid to a spouse in a divorce. So the procedures for dividing an IRA in a divorce can be much more complex. 

This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of tax by keeping you up-to-date on new and pending changes in tax laws, providing tips to lower your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of The Kiplinger Tax Letter or subscribe. 

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Joy Taylor
Editor, The Kiplinger Tax Letter

Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.