Do You Have to Pay Taxes on a 401k Divorce Settlement?
What is the benefit of this action? First, let’s talk about what a 401(k) does for its owners.
Benefits of a 401(k)
Putting money into a 401k plan allows people to save pre-tax dollars on that money. Essentially, you sequester money for the future and agree to pay taxes when you withdraw it during retirement.
Using a 401(k) can significantly reduce your current tax burden. For example, if you deposited $5,000 into your 401(k) in 2020, you could reduce your taxable income in 2020 by $5,000. In some cases, that could help pop you into a different tax bracket.
During marriage, the money you deposit into a 401(k) is shared, as are the interest payments earned by the 401(k). When you divorce, you must split those assets.
If you split the assets by transferring money into a new retirement account with the same types of rules, you won’t have to pay taxes. You’re just sliding from one account to the other.
Why? Because 401(k) plans aren’t taxable until you retire and begin drawing money from the account. At that point, you will pay taxes on the withdrawals.
However, if you pull cash out of the account before you’re old enough to do so (to give a share to your ex, for example), that income can be taxed. And you could be forced to pay penalties for that early withdrawal. In other words, moving money out of the account during a divorce could come with penalties and tax consequences.
When else might you be required to pay tax on 401(k) money?
The choices you make regarding 401(k) funds could prompt a big tax bill during the year your divorce becomes final. Common choices that could come with tax consequences include the following:
- Liquidation: Some people opt to dissolve their 401(k) accounts and take the cash in divorce. This could be considered an early payout that is taxable.
- Trades: Some people give up their rights to a 401(k) by accepting another asset, such as a house. A trade like this may come with significant tax consequences.
When deciding how to split 401(k) funds in a divorce, it’s important to think carefully about the tax consequences of every option before you make your final decision. As mentioned above, transferring the money to a new 401(k) account may help you reduce your tax burden while ensuring that you are still saving for your future retirement.
What divorcing people need to know about QDROs
Regardless of your age upon divorce, you need to understand what a qualified domestic relations order, or QDRO, is.
A QDRO is a set of instructions for your 401(k) plan administrator. It contains information about how the account should be split in a divorce situation. Many companies require these forms before they will move money out of the account.
Need help with your QDRO? Our trusted partner, SimpleQDRO, can help.
A QDRO can’t offer benefits that aren’t available under the plan. For example, it can’t lower the age at which you can access funds without a tax penalty. And it can’t give you more money than exists within the account.
Some QDROs allow people to open new accounts with the company, transferring funds from one 401(k) to a new one. After the transfer, both parties have separate accounts set up and functioning as retirement savings tools.
To refine your understanding, we recommend reading our articles, What is a QDRO? and What Happens If a QDRO Is Not Filed?
Conclusion
If a retirement account is part of your estate, proceed carefully. Be aware that when you split your retirement account assets with your soon-to-be ex-spouse, there could be tax consequences. But if you go about it carefully, consulting a financial planner who understands divorce law (like a CDFA), you may be able to avoid paying taxes.
A QDRO can help you specify the split of your 401(k) funds. Negotiate with your spouse on a split that’s equitable and fair, and put those plans in writing with a QDRO. If this sounds daunting – which many people find to be the case – ask a qualified professional to help you draft a QDRO that’s accepted by your 401(k) company.
If you’re considering a different approach, talk through that idea with a financial expert, too. Get their advice, and run the numbers several times before you make a final choice. The steps you take now could save you a lot of money in the future.
References
Who Has Retirement Accounts? (August 2022). United States Census Bureau.Retirement Topics: Divorce. (August 2023). Internal Revenue Service.
The Beginner’s Guide to 401(k)s. (August 2023). FINRA.
Tricky Divorce Issue: How to Divide 401(k)s, IRAs, and Annuities. (September 2020). Kiplinger.
Retirement Topics, QDRO: Qualified Domestic Relations Order. (August 2023). Internal Revenue Service.
