Preparing for divorce means taking a careful account of one’s personal circumstances. People need to look at their finances and their property. They have to learn about state law. They then need to prepare to negotiate with their spouse or present their case in family court.
Some assets are harder to divide than others. Retirement accounts, for example, create a host of challenges. Many people fear the need to divide retirement savings because of the possibility of penalties. 401(k)s are among the most popular solutions for those saving for retirement. They are often at least partially part of the marital estate, which means people may have to split them when they divorce.
Is it possible to do so without incurring major tax consequences and financial penalties?
What are the early withdrawal penalties?
There are two negative consequences associated with an early withdrawal from a 401(k). The first is the penalty assessed. Typically, the account holder has to pay a 10% penalty based on the amount that they withdraw before they reach retirement age.
The second consequence has to do with taxes. 401(k) contributions are typically pre-tax income, which helps them limit what they pay in income taxes each year. Those who make a substantial withdrawal have to report those funds as part of their annual income. That may push them into a higher tax bracket.
Thankfully, there’s a way to avoid both of those consequences in a divorce.
Proper paperwork prevents penalties
Those with 401(k)s who need to divide them as part of a divorce can avoid the penalties associated with early withdrawals by following the right procedure. Having a lawyer draft a qualified domestic relations order (QDRO) allows for the penalty-free division of the account into two separate accounts. Provided that no additional withdrawals occur, there should not be any tax consequences either.
Spouses can also potentially negotiate arrangements in which they do not have to divide the account because they account for its value elsewhere in the property division process. Either approach can eliminate the risk of tax penalties and other consequences during a divorce.
Having a plan for addressing one’s most valuable marital property can help people avoid costly consequences during a divorce. Those with more complex marital estates often need to plan carefully when making financial moves as their situation evolves.