When professionals have 401(k)s and similar tax-deferred accounts, they may need to take extra care during the property division process of a divorce. Tax-deferred retirement savings accounts exist to provide a nest egg for those without regular income.
Dividing an account during retirement could lead to significant losses. The use of a qualified domestic relations order (QDRO) can facilitate the division of an account while eliminating the standard financial consequences of early withdrawals.
There are penalties for premature withdrawals
Policies related to tax-deferred retirement accounts aim to deter people from withdrawing funds before they reach retirement age. Early withdrawals from 401(k)s typically lead to a 10% penalty. The account holder loses not just the amount withdrawn but an additional 10% of that amount.
They also have to report the amount that they withdrew as income and factor that into their income tax return for the year. Sizable withdrawals, such as money removed to split the account in half due to a divorce, could push people into a different tax bracket and cause a cascade of financial complications.
A QDRO approved by the courts eliminates early withdrawal fees. Instead of one party withdrawing the funds as liquid cash, the professional managing the account moves a specific percentage of the balance into a new account in the name of the other spouse. When properly executed, QDROs help protect professionals from tax consequences and the 10% penalty imposed for early withdrawals.
Spouses may also want to explore ways to integrate the value of the account into their property division settlement without actually splitting the account. The circumstances of the spouses largely determine the best solution. Learning more about the most challenging issues during property division can help people preserve their resources for rebuilding after a divorce.