Retirement savings often represent years of hard work and sacrifice. A well-funded 401(k) or similar retirement account can supplement Social Security retirement benefits and help people cover their costs when they no longer work full-time jobs.
If people divorce, splitting their retirement savings can be an important part of the property division process. Spouses may determine that actually splitting an account is the simplest solution for addressing it during a divorce, or a judge might order the division of the account.
In either scenario, the spouses likely need to have a lawyer draft a qualified domestic relations order (QDRO). Seeing to the prompt creation of a QDRO can make a significant difference by protecting people from several predictable financial consequences.
1. Early withdrawal penalties
401(k)s and similar tax-deferred retirement savings accounts are subject to rules that people must follow. Those rules include prohibitions on early withdrawals. Account holders typically cannot withdraw funds before they reach retirement age. If they do withdraw funds, they are subject to a 10% penalty. They lose not just the amount that they take out of the account but an additional 10% on top of that amount. When properly executed, a QDRO protects the account holder from the penalty associated with early withdrawals.
2. Income tax consequences
The removal of retirement savings funds from a tax-deferred account can lead to an increase in income tax obligations. The amount that the account holder withdraws becomes taxable income that they must report to the Internal Revenue Service (IRS). In some cases, significant withdrawals are enough to push people into a higher tax bracket. Even if they remain in the same bracket, they can expect a substantial increase in their income tax obligations for the year. When people use a QDRO to move funds from a retirement account into a new account in the other spouse’s name, they do not have to declare the withdrawn amount as income.
3. Intentional withdrawals
People who have to share their resources with their spouses often resent that obligation. They might accept the penalties associated with early withdrawals and pull funds from the account prematurely. Then, when the spouses do finally split the account, the balance available to divide is substantially lower than it was during the divorce. Given that a QDRO typically expresses the amount granted to the other spouse as a percentage, that misconduct can have significant consequences.
Working with an attorney to draft a QDRO helps people preserve as much of their retirement resources as possible despite divorcing.