A lot of people getting divorced are not aware that the IRS, yes that IRS, recognizes that people getting divorced have an unusual situation that could benefit by some reasonable exceptions to their usual rules.

One that is often overlooked is the elimination of the 10% tax penalty for 401(k) withdrawals done as part of a divorce property settlement agreement.

Ordinarily 401(k) and other qualified plans require funds not be withdrawn before the age of 59 1/2. Withdrawals are always taxed at the state and federal level along with other income earned during the year at whatever tax bracket you end up in. If you take out the funds early you pay an additional 10% federal tax. This can mean losing up to 50% of your withdrawal to state and federal taxes and penalties

But if you are divorcing and have a court approved settlement you avoid the 10% penalty as funds go from one party to another. This is really significant because often the largest amount of liquid assets are in the family’s retirement accounts. Much more than is usually in investment and bank accounts.

The Case of Pat and John

Here is a real world example from a couple I worked with.

Pat and John had a solid financial life in many ways; good paying stable jobs, one for a university, the other for the government, a modest yet satisfying lifestyle, and a home with good equity. As a couple with nearly grown children and later in their careers they had over $500,000 in retirement accounts, but little in the bank or in investment accounts. And they also had $25,000 in credit card debt accumulated a bit at a time to cover bills while their children were in college. This debt was clearly going to be a threat to their financial security in their new lives as it cost them over $4,500 per year in interest alone.

So we did the math and calculated that they could eliminate this debt with a single withdrawal out of the largest 401(k), and that the taxes they would owe would be paid for in just over two years through savings on credit card interest. They could go into their new lives with zero credit card debt and save hundreds of dollars per month in credit card payments. Not a bad decision.

Please talk to your tax accountant if you think you want to use this strategy. But here are the basics of how this works.

• You need to calculate the benefits first; what will you save in interest payments, and what will you pay in taxes? Ideally funds go from the higher earner’s retirement account to the lower earning spouse who may be in a lower tax bracket.

• You must have the transfer be part of your formal marital property settlement. You can only do this if you are getting divorced and have an approved agreement.

• The transaction must be done carefully;

  • You need a Qualified Domestic Relations Order (QDRO) prepared and signed off on by both the court and plan sponsor that specifies all the details. And there are lots of details.

  • The funds coming out of the retirement plan must go directly into a taxable account. You cannot first transfer them into an IRA and then take the withdrawal. Big mistake to do otherwise.

• You can’t do this from IRA accounts, even if the funds had previously been in a company retirement plan. You just can’t. It has to be a company retirement plan such as a 401(k) or 403(b).

  • NOTE: If you have an IRA you can also avoid the penalty through “annuitizing” the account - taking it out in small pieces over time…but that is for another article. Click here to go to the IRS topic about “72-t” distributions. Or just email me.

You will want to have an accountant or Certified Divorce Financial Analyst (CDFA) run an analysis for you so you know the costs and benefits before you act. It takes some number crunching to nail down the benefits. (It is work we do.)

The IRS has a document on everything tax related divorcing people should know about. Click here to go to it. It is a little dry, but after all it is the IRS.

So this is a smart strategy to pay down debt, or to create funds for a down payment on a new residence. Or even just to have spendable cash to start off your new life with.

There are lots of little strategies and loopholes to know about to help you be Financially Smart during your divorce. We will be writing more articles on tax topics, but I hope this was helpful as a start.

As always you can get in touch with me at wentworthplanning@gmail.com, or phone at 401 533-4142 to talk further about how we can help.

J.A. Licciardello is the author of The Financially Smart Divorce” available on Amazon.

He is also a mediator and Certified Divorce Financial Analyst (CDFA) with Wentworth Divorce Consultants.

More information can be found at www.wentworthdivorceconsultants.com