For many people, the years put into saving for retirement make the thought of losing a large chunk of that savings almost unbearable. Unfortunately, some spouses must split their 401K accounts when they get divorced.
In standard cases, when a person withdraws money from their 401K account for any purpose other than to fund retirement, they may end up paying very high early withdrawal penalties as well as income tax. Together, the penalties and taxes may dramatically reduce the amount of money the person nets. A divorce-related distribution may avoid these with the use of a qualified domestic relations order.
QDROs and the additional payee
As explained by the United States Department of Labor, a person may add their spouse or former spouse as a legal payee onto their 401K or other employer-sponsored retirement account through a qualified domestic relations order. The QDRO not only identifies the spouse as a person legally able to receive distributions from the account but also identifies the amount or percent of the fund’s value to be distributed to that person.
When a couple agrees to split the 401K account as part of their property division settlement, the spouse of the account owner receives money directly, bypassing the account owner and eliminating the need for them to pay penalties. The spouse also avoids early withdrawal penalties due to the QDRO.
Taxes and QDROs
Employer-sponsored retirement accounts are funded with pretax dollars, requiring income tax to be paid at the time of distribution. According to the Internal Revenue Service, the spouse receiving the funds assumes liability for the taxes. By reinvesting the money into another retirement fund, however, the recipient need not pay taxes upon receipt of the money.