Dealing With Your 401k During Divorce
An exception to the 10% penalty on distributions from a qualified plan (but not an IRA) is when the distribution is pursuant to the imposition of a Qualified Domestic Relations Order, or QDRO (cue-DRO).
A QDRO is often put into place as part of a divorce settlement, especially when one spouse has a considerably larger retirement plan balance than the other. What happens in this case is that the court determines what amount (usually a percentage, although it could be a specific dollar amount) of retirement plan’s balance is to be presented to the non-owning spouse. Once that amount is determined and finalized by the court, a QDRO is drafted and provided to the non-owning spouse, which allows the non-owning spouse to direct the retirement plan custodian to distribute the funds in the amount specified.
In the case of a QDRO, the owning spouse will not be taxed or penalized on the distribution. In addition, if the non-owning spouse chooses to roll the distribution into an IRA, there would be no tax or penalty on the distribution to her, either. If the non-owning spouse chooses to use the funds in any fashion other than rolling over into another qualified plan or IRA, there will be tax on the distribution, but no penalty.
Many times it may make sense for the non-owning spouse to leave the account with the qualified plan (rather than rolling into an IRA) if there may be a need for the funds at some point in the future. This will be dependent upon just how “divorce friendly” the qualified plan custodian will be.
Of course other 72(t) exceptions could apply, but if there was a need that did not fit the exceptions and the distributee did not wish to establish a series of substantially equal payments for five years, the QDRO would still apply to the distribution from the qualified plan (as long as the funds are still in the plan that the QDRO was written to apply to).
As an example, let’s say Lester and Edwina (both age 40) are divorcing, and as a part of the divorce settlement, Edwina’s 401(k) plan is to be shared with Lester, 50/50, with a QDRO enforcing the split. After a couple of years Lester decides he would like to use some of the funds awarded to him from the divorce to purchase a new fishing boat. As long as the funds are still held in Edwina’s 401(k) plan, Lester can request withdrawal and receive the funds without penalty, due to the existence of the QDRO. However, had Lester rolled over the funds into an IRA (or other qualified plan), the QDRO would no longer be in effect, and he would be unable to access the funds without paying the penalty for early withdrawal. (It is important to note that, in either case, Lester would be required to pay ordinary income tax on the distribution.)