Accessing Money from a Defined Contribution Plan Without the 10% penalty
Normally, distributions made before the participant attains age 59-1/2 are called “early distributions,” and are subject to a 10% penalty tax. The tax does not apply to early distributions upon death, disability, annuity payments for the life expectancy of the individual, or distributions made to an ex-spouse by a QDRO.
The tax Reg (72)(t)(2)(C) states that when you take money out of a qualified plan in accordance with a written divorce instrument (a QDRO), the recipient can spend any or all of it without paying the 10% penalty.
Let’s take a look at what happens when the ex-spouse receives the 401(k) asset. There are some specific rules to be aware of.
Here’s an example.
Sarah was married to an airline pilot who was nearing retirement. They were both age 55. There was $640,000 inhis 401(k) and the retirement plan was prepared to transfer $320,000 to her IRA. She could transfer the money to an IRA and pay no taxes on this amount until she withdraws funds from the IRA. But Sarah’s attorney’s fees were $60,000 and she needed another $20,000 to fix her roof. She said, “I need $80,000.”
Because the 401(k) withholds 20% to apply toward taxes on a withdrawal, Sarah asked for $100,000. After the 20% withholding, she had $80,000 in cash and $220,000 to transfer to her IRA. She was able to spend the $80,000 without incurring a 10% penalty on the $100,000, which saved her $10,000 in penalties.
After the money from a pension plan goes into an IRA, which is not considered a qualified plan, Sarah is held to the early withdrawal rule. If she says, “Oh I forgot, I need another $5,000 to buy a car,” it is too late.
She will have to pay the 10% penalty and the taxes on that money. Or, if Sarah’s financial advisor did not know about this rule and established an IRA to receive the funds from the QDRO, and then she decided to take a withdrawal to pay her attorney’s fees (or a withdrawal for ANY other reason); she would be assessed a penalty of 10% in addition to the normal ordinary income tax due on the distribution.
Types of Qualified Plans
It is important to understand the subtle differences when transferring money from qualified plans. One type is a direct rollover where the check is made payable to the company where the IRA is held; not payable to the client. The check may be sent directly to the IRA custodian or the client, however, the check is made payable to the custodian of the funds.
The other type is a 60-day rollover, where the distribution is made payable to the client with 20% withheld for Federal taxes. It is then up to the client to get the funds back into an IRA within 60 days. Additionally, the client must put in the additional 20% withheld for federal taxes for the entire transaction to be a non-taxable event.
The Unemployment Compensation Amendment Act (UCA), which took effect in January 1993, stated that any monies taken out of a qualified plan or tax-sheltered annuity would be subject to 20% withholding. This rule does not apply to IRAs or SEPs.
In other words, if money is transferred from a qualified plan to an IRA, the check is sent directly from the qualified plan to the IRA. In a rollover, the funds are paid to the person who then remits the money to an IRA. A payment to the person, whether or not there is a rollover, is subject to the 20% withholding. Only a direct transfer avoids the withholding tax.
This is a great planning tool when clients have a need for cash and there is no other way to get it.
It has been said that divorce lawyers have the highest number of malpractice claims. One reason may be that while advising their clients on settlement issues, the lawyer may be giving improper financial advice. This is commonly due to the constant changes in tax law and perhaps the fact that the divorce lawyer’s expertise is in the law, not in taxes.
Basis in Property is a Big Issue
After being involved with over thousands of divorce cases, we find that the one question most overlooked by divorce professionals is: What is the basis in the house (or stocks, other real estate, or other investments in the couple’s portfolio)? Consider the following case study.
Melanie and Mac have been married for 18 years. They have no children. They have decided everything except how to divide the remaining three assets equally. Those assets are a cottage in Hawaii worth $350,000, an IRA worth $150,000 and a savings account worth $250,000. The $250,000 in the savings account represents a loan taken against the cottage in Hawaii.
Mac proposed to Melanie that she take the cottage and sell it. She would net $100,000. And she should also take the IRA worth $150,000. He would take the savings account and they would each end up with $250,000.
His proposal looked like this:
Melanie talked this over with her attorney and they thought that this sounded fair. But, is this truly an equal division? It depends on. . . . THE BASIS?”
Had the divorce professional inquired about the basis in these assets, it would have been revealed that Mac had paid $90,000 for the cottage 15 years earlier. It was sold at an incredible estate sale. There was a $260,000 capital gain, which created a tax of $52,000 (capital gains tax at 15% plus state tax at 5%). Melanie received $100,000 and had to pay out $52,000, so she had only $48,000 left.
The after-tax value of the IRA is approximately $100,000 (not counting penalties as she is not planning to liquidate it immediately), so Melanie ends up with $148,000. The $250,000 that Mac borrowed from the cabin and put in the savings account was his, tax-free and clear.
He ends up with $250,000 and she ends up with $148,000, because the question was not asked about the basis. Do you think Melanie’s attorney had some liability here? Absolutely!
Be sure to investigate the basis in all assets. Then there will be no surprises.
Can We Sell Our Home Before We are Officially Divorced?
If you’re thinking about beginning divorce proceedings, chances are your combined marital assets are weighing heavily on your mind. What will the outcome be? Can we afford to support two households? How will the changes in income affect our children?
When it comes to assets, often the family home is a big part of the financial picture and figuring out all of your options might feel overwhelming. So, let’s take a look at what you should be considering when it comes to your real estate investments and working through mediation.
Let’s start from the beginning.
When we look at the real estate that a couple jointly owns, we’re including not only the residence, but also any rentals, timeshares, and land. We also know it is important to do a complete forward-looking cash flow analysis; this helps the client see the future financial picture of home ownership. Through this process, we can show them what price ranges make the most financial sense once the household is divided into two.
What if we decide to sell our home before the divorce is final?
Should the clients have children still living at home and decide to sell, we encourage them to spend some time looking at the following:
1. Different neighborhoods
2. School districts
3. Proximity to the other parent
4. Nearness to the children’s activities.
For those clients who are considering divorce and are closer to their retirement date, it is also important for them look ahead at the following:
1. Amenities they would need/enjoy in their retirement.
2. What type of home they would prefer (one-story, retirement community, etc.).
3. Proximity to healthcare facilities.
When it comes to the logistics of the sale, it’s also important to work through the details of the transaction. Here are some other factors to consider:
1. Who is going to pay for the normal expenses during the pendency of the sale?
2. Who is responsible for the ‘market readiness costs?
3. If one spouse pays the expenses, will they be reimbursed from the proceeds?
4. How will you select a realtor?
5. How will the net sales proceeds be divided?
Sometimes, especially in the current Colorado real estate market, a marital residence must be sold in order to secure another residence. Because this transaction and its timing is so complex, it is of utmost importance that all angles are analyzed, and the impact known; this includes the moving and market readiness costs that are involved and how the marital residence is titled along with other potential issues with lenders.
Therefore, we feel that it’s important to choose a mediator who works closely with realtors and lending professionals to make certain that this transaction is doable prior to the finality of the divorce and that it can be done without any potential future negative results.
The bottom line is: It is possible to sell the residence during the pendency of the divorce, but it must be carefully analyzed.
Client Question: Access to Financial Information During Divorce
If you’re contemplating getting a divorce and you’re feeling fearful and overwhelmed, you’re not alone. Aside from feeling uncertain about the future, there’s also the worry about your future financial situation as you divide one household into two, financially.
A very common question we’re asked at the Divorce Resource Centre of Colorado is this:
My husband handled and has access to our finances and all the banking and investment information. What should I do?
First, it’s advisable to order your credit report as it will list all your credit history. The credit reports do not have your entire account number shown. You should find and record each full account number which you will need as you implement your property division.
What DRCC Recommends
During a divorce, any assets or funds contained in a joint bank or investment account are generally considered marital property. These funds belong to both spouses, even though one person may have been responsible for the majority of the deposits and contributions. It is important that you don’t unilaterally remove funds from these accounts without professional guidance as you enter the divorce process. (SOURCE: Deb Johnson, ChFC, CDFA Divorce Resource Centre of Colorado.)
The first thing you need to do is gather all the financial information possible:
- - Photocopy or take pictures of statements (both bank, investment and retirement accounts.
- - Write down names of banks or investment firms AND account numbers.
- - Photocopy or take pictures of tax returns (at least the most recent 3 years.
- - It is helpful to copy any loan applications (HELOC, auto, business) as this gives us a benchmark of the family financial situation prior to the divorce.
This information will be used later to identify all your marital assets/liabilities, which will be used to create anequitable division between you and your spouse.
What if one of the spouses withdraws funds?
According to Avvo.com, “You can legally withdraw up to half of the money in a joint bank account before the divorce is filed. It is extremely important that this is done before the divorce is filed; otherwise you are violating the law.”
Even with this information from Avvo.com, it is most important to consult a professional before removing/transferring funds.
Let us help
As with all divorce matters, it’s important to consult with a professional who will help guide you through the process. If you’re looking for advice from several different professionals before you consider hiring someone, we recommend you attend a Second Saturday workshop hosted by Divorce Resource Denver. Meeting times are listed here.