There are many benefits to funding a 401(k) account. The professional making deposits into the account can diminish their taxable income for the year. Their contributions involved pre-tax income. The funds set aside for retirement are then subject to income tax later in life when personal income is much lower.
Professionals who fund 401(k)s may have sizable nest eggs to ensure their financial comfort during retirement. Current regulations on 401(k)s deter premature withdrawals that can undermine an individual’s financial security during their golden years.
Anyone who makes withdrawals before retirement age is typically subject to a 10% penalty. They lose another 10% on top of whatever they withdraw from the account. Divorcing couples may use qualified domestic relations orders (QDROs) to split their retirement accounts. Could a penalty still apply after the proper use of a QDRO?
Post-split choices determine if there is a penalty
A QDRO provides a legal opportunity for a penalty-free transaction without any tax consequences either. When the property division decree includes specific instructions for the division of a 401(k), drafting and recording a QDRO allows the current account holder to avoid any penalties or taxes.
The professional managing the account and applying the QDRO withdraws a specific portion of the account’s balance in accordance with the terms of the QDRO. Then, they deposit those funds into a brand new account created in the name of the other spouse. So long as the recipient spouse leaves those funds in the new 401(k) account until they reach retirement age, there are no tax consequences or penalties for receiving a portion of a retirement account as part of the divorce.
However, if the recipient spouse then decides to withdraw some or all of those funds to cover divorce costs or establish a separate household, they could be at risk of penalties and tax consequences. Avoiding those financial consequences is only an option when the funds remain in a 401(k) after their split.
Discussing financial plans with a skilled legal team before making any major money moves can help people avoid economic setbacks following a divorce. People who have support when negotiating the terms for and drafting a QDRO are less likely to make mistakes that could result in penalties.