Sometimes divorcing couples think they can make an end-run around a qualified domestic relations order (QDRO) and simply have the participant withdraw money prematurely from a 401(k) account and pay it to the ex-spouse. We are commonly asked questions about this scheme. Short answer: Really bad idea.
A premature distribution from a 401(k) is subject to a 10% tax “penalty” and destroys the tax sheltered nature of the withdrawn amount. Gains, if any, on the withdrawn amount would be taxable in the tax year the money is withdrawn in addition to the 10% tax penalty. With a QDRO, the tax penalty is avoided and the tax-sheltered nature of the ex-spouse’s award can be preserved by either segregating the money into an account for the ex-spouse’s benefit with the plan (if permitted by the plan) or directly rolling the money over into an IRA. I’ll leave open the possibility that if, and only if, the 401(k) award is less than $4,500 in it and the ex-spouse intends to take an immediate distribution and capital gains on the $4,500 is minimal, then the cost of preparing a QDRO ($450) may exceed the tax penalty. Frankly, I’ve never encountered this situation.
On the pension side (defined benefit plans), there really is no end-run around a QDRO at all. Even if the participant agrees to make monthly payments to the ex-spouse and the ex-spouse trusts the participant, the ex-spouse would be forced into a shared payment arrangement, would be unable to draw at the participant’s earliest retirement age and, most importantly, benefits would cease upon the prior death of the participant (read our article on survivorship rights). To further complicate matters, the parties would not avail themselves to Section 72(m)(10) of the Internal Revenue Code and the participant would bear the tax bill for the entire pension payment. Adjusting for taxes in such a situation would likely turn into a dispute between the parties.
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