Why 401(k) splits are getting more complicated
Now that more and more households are amassing bigger 401(k) balances , and the outlook for interest rates and the stock market still has a big say in retirement planning; with all this in the mix, it's no wonder divorces are increasingly involving big 401(k) balances. Couples often prefer to just transfer the whole lot or get a straight-up award of 401(k) funds to help sort out alimony and property division because it makes life afterwards a whole lot simpler - no more worrying about cash flows down the line. But, federal rules and the small print in 401(k) plans have specific rules about plan transfers and the tax implications are just as tricky as any old cash alimony payment the IRS.
What just happens when someone gets a QDRO
- QDRO 101: A Qualified Domestic Relations Order is basically a court order that tells a 401(k) plan to pay its benefits over to some new person (spouse, ex, or kid) and to make sure it's done right, the order has to meet the plan and IRS rules to count.
- Skip the middle man: When a QDRO is used - the plan administrators can just cut the 401(k) check straight to the new owner or into an IRA in their name - no need for the original owner to pay taxes on it first, nice for the IRS.
Tax treatment when dividing up the cash - alimony vs property division
The key difference: If the transfer is treated as part of dividing up the family assets in the divorce papers and gets sorted out via a QDRO then the recipient gets to report any distributions they take as income from the 401(k) - as and when they get it, not as alimony income in the year they get it all. That's a better deal for them - they pay taxes on the cash they take, but the other person doesn't get a tax write off for the transfer. On the other hand, if the agreement spells out the payments as periodic alimony ( keep in mind that the tax rules changed in 2018 - so what really matters is when the divorce was finalized, the language in the settlement and the timing) then we have different tax rules - the way the whole thing is taxed is different to the first scenario - and that's before we get to the little matter of the deductibility of alimony, which has changed in recent years.
Penalties and exceptions
Dodging that pesky 10% early-withdrawal penalty: When a well-crafted QDRO transfers cash directly to an alternate payee or to an IRA in their name the 10% early penalty that usually gets slapped on early withdrawals before you hit 59 1/2 just doesn't apply. But before you breathe a sigh of relief, plan administrators and courts have got to follow a pretty strict set of rules - make one little mistake in the QDRO or in the way the plan is worked out and you could find yourself facing a whole heap of unexpected tax liability or even a penalty - so getting an expert to review it for you is crucial.
Tips for nudging along high-value settlements with a well drafted QDRO
- Make it clear: Spell it out in black and white - whether what you're splitting is marital property or alimony and make sure to reference the QDRO rules so the plan administrators know exactly what to do without getting bogged down by any confusion.
- Timing is everything: Decide whether your alternate payee wants to start taking cash right away or roll it all into an IRA to keep a lid on their tax bracket.
- Get your tax ducks in a row: Work with a tax expert to get the divorce decree, QDRO and tax reporting all lined up so both parties know who's liable and when.
Tax planning that'll keep you on the right side of the law
Delaying distributions and playing with tax brackets: If your alternate payee rolls the QDRO award into an IRA, they can hold off on taking cash until they're well into retirement or in a lower tax bracket - which will save them a pretty penny in tax over the long run. Breaking a big award down into smaller staged distributions or even converting bits of it to a Roth account (where allowed, of course, and only after giving it some serious thought) could also be a big part of an overall tax-aware strategy.
Coordinating the team: With so many different rules to navigate - plan rules, state divorce law and federal tax law all intersecting in a big heap of complexity - it makes sense to get a team together - a family-law attorney, a tax advisor and a specialist who knows retirement plans inside out so you can get this right first time and avoid any costly mistakes along the way.
Where to go for the real lowdown
For the lowdown on QDROs and retirement plan distributions you can't go past the IRS's QDROs and retirement topics page or reputable family-law resources that spell out how all the different rules and regulations fit together - like the IRS guide.
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