The Tax Consequences of 401(k) in a Divorce Settlement
A 401(k) plan is your best investment for retirement in many instances. If your employer contributes to your retirement, the matching contribution could be a windfall for you. Unfortunately, it could also be a windfall for your spouse if you get divorces. Your spouse is entitled to half of your retirement assets if you live in a state enforcing community property laws.
A court may order a qualified domestic relations order. This order, which can be initiated by your ex-spouse, is an order which mandates your retirement account be split between the two of you. Your retirement plan administrator must comply with the order. The order specifies how much of your assets are transferred to your ex-spouse. QDROs may also be used in cases where you owe alimony or child support.
The 401(k) plan is transferred on an income tax-free basis to your ex-spouse. This money is considered a direct transfer in the eyes of the IRS, and not subject to premature withdrawal penalties or income tax.
The transfer is normally made to another retirement account, such as an IRA in the name of your spouse. Normally, the Employee Retirement Income Security Act (ERISA) prohibits this procedure, but the QDRO is an exception to the law in a divorce.
The benefit for the receiving spouse is that money is received income tax-free. This money is treated as though it were their own. They may add to the retirement account and make withdrawals according to the rules established for the account they have set up in their name. Taxes are not due on the retirement plan money until withdrawals are made. Earnings in Roth accounts is tax-free after age 59 1/2 if you have held the account for at least five years.
Do not circumvent the QDRO. Any money transferred outside of the QDRO is subject to income tax and a penalty if the withdrawal is made prior to age 59 1/2. You cannot effectively make a private deal or settle out of court with your ex-spouse in regard to your retirement plan. If your spouse believes that she is entitled to half of your retirement funds, she should request the appropriate action by the court, which will avoid a costly transfer.