401k Distribution
Assets inside a 401K must be split equally as described in a divorce decree. Client is thinking of taking a tax-free loan for the amount owed the spouse.
If client asks for a check instead of a loan, what would be the tax ramification to client and/or ex-spouse since she is required to separate this asset?
Permalink Submitted by Alan Spross on Mon, 2011-02-14 19:55
The QDRO required to partition the 401k should include all the details regarding any loans, eg in a 50-50 split is the loan balance included or not?
If client wants to take a loan from the plan to avoid a QDRO filing in the first place, the loan could be taken by the client to pay ex and would not be currently taxable, but if client fails to repay the loan due to job loss or otherwise, the client will be taxed when the plan issues a deemed distribution for the balance and reports it on a 1099R. There will also be a 10% early withdrawal penalty unless client is over 59.5 or qualifies for another exception. In that case, the ex would receive after tax money and the client would get hit with the taxes on it.
If ex secures a QDRO, the plan will have to partition the accounts but that will not enable a distribution from the plan unless the plan allows for a distribution. If a distribution is allowed, the ex (aka alternate payee) can take a distribution penalty free using the QDRO exception. However. if the ex rolls the plan balance over to an IRA, distributions from the IRS do NOT get the QDRO exception and the ex may then be forced into a 72t plan to avoid penalties if not yet 59.5.
The worst thing the client can do is to take a distribution from the 401k to pay off the ex. Client will be taxed and penalized if not 59.5, and the ex would receive funds post tax. Divorce attorneys should draft QDROs and calculate settlements based on the after tax value of retirement accounts using the projected tax brackets of each spouse. That prevents the IRS from getting an excessive share of the settlement, and also prevents early withdrawal penalties if done correctly.