Spouses involved in divorces frequently have an immediate need for cash at the time their divorce is finalized, to pay bills, make a down payment on a home or secure an apartment, or for other reasons, but lack any significant non-retirement assets from which they can obtain such funds. Often, the only significant assets of parties at the conclusion of a divorce are funds in employer-sponsored qualified retirement accounts, such as 401(k)s or other defined contribution plans. In these instances, the 401(k)s or other qualified retirement accounts will be divided between the parties. The party receiving funds from his or her spouse’s retirement account is known at the “alternate payee.” There are no tax consequences or penalties at the time of the transfer so long as the parties obtain a Qualified Domestic Relations Order (“QDRO”) from the court and the funds are rolled into an Individual Retirement Account (“IRA”) in the name of the alternate payee.
The transfer of funds pursuant to a QDRO also presents a one-time opportunity for the alternate payee spouse to withdraw money from the qualified retirement account penalty-free. Generally, the owner of a qualified retirement account or IRA must wait until he or she reaches the age 59½ to receive distributions. If a person withdraws money from one of these accounts prior to that date, he or she faces a 10% penalty on the withdrawal, in addition to the federal and state taxes owed.
In divorce cases, however, the Internal Revenue Code carves out an exception to the 10% penalty rule and permits an alternate payee only to request a partial or total cash distribution of their share of the qualified retirement account, provided that the request is made prior to rolling the funds into the IRA. The alternate payee is still required to pay taxes on the distribution, but he or she will not incur the 10% penalty. It is important to note that each financial institution drafts its own rules and regulations governing its retirement accounts and, therefore, this option might not be available with every retirement plan.
The attorneys at Cooley & Handy can help you investigate this and other options to help secure your financial future following your divorce.