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.
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.
Divorce Mediators: One size does NOT fit all
We get multiple bids from contractors to help us with renovations. We test-drive several cars before we purchase one. We would never embark on a vacation without doing a little research first.
So, it would make sense that when it comes to something as sensitive as divorce, we should ensure we find the right fit for our needs.
Mediators come with different backgrounds and levels of experience. Some have a background in social work, psychology, and family systems. Some have experience with financial services or legal expertise. Depending on the various issues in your own case, you will want to fully understand the prospective mediator’s background and experience as it relates to you and what will best suit your situation and personality.
In an article on Mediate.com, they suggest you ask the following questions when looking for a mediator:
1. How has your education and experience prepared you to help us work out this specific dispute?
2. Do you participate in continuing education, on-going supervision, or consultation?
3. What values and goals do you emphasize in your practice?
4. Which ethical standards do you follow, and may I obtain a copy of those standards?
5. Do you have a prior relationship with any of the parties or their attorneys?
6. Can you please explain your confidentiality agreement?
7. How would you estimate costs for this case?
“It’s important to work with a mediator that, at the very least, has a 40-hour certificate demonstrating the basic mediation skills,” says Deb Johnson with Divorce Resource Centre of Colorado. “It’s also crucial to work with someone who truly wants the best outcome possible.”
Thinking About Divorce?
Here's what you need to know about mediation.
If you’re at the beginning of the divorce process or if this is something you’re considering in the future, it’s important to know all the facts. You might be wondering how to begin the process, what information you’ll need to bring with you when talking to a divorce professional, and how to move forward.
At Divorce Resource Centre of Colorado we believe it’s important for you to be educated about the process of mediation; knowing what’s ahead will hopefully alleviate some of the fear of the unknown, the stress you might be feeling, and make you feel less overwhelmed with the process.
Let’s get started
Before the commencement of any divorce action, it is necessary for all parties to fully disclose all their financial information. Once retained, DRCC provides our clients with the following:
~ A checklist of all financial disclosures they will be responsible for gathering.
~ A spending plan that looks toward what finances and cash flow will look like after divorce and into the future.
Your Guiding Principles
Prior to forging ahead with the mediation process, it is important for everyone to spend some time setting an intention on what they want the outcome of their divorce to look like. While much of what we assist with is your comprehensive financial picture, there are other outside components that help us piece together a plan that will benefit both you and your family.
Some questions you might ask yourself when determining your guiding principles are:
~ Is it important to have an amicable and dignified divorce so that we can successfully co-parent for years to come?
~ What does a “healthy divorce” mean to you?
~ What are the children’s best interests?
It’s also important to be aware of any triggers you might have concerning your spouse. Do those triggers involve money? Parenting styles? Family? By identifying these issues, you are more aware of how you react when they come up; that makes it easier to keep those guiding principles in mind.
By being an active participant in the mediation process, your chances of creating an outcome that both parties can agree with are greater. Negotiated agreements have many benefits over a judge’s ruling: they take less time, they reduce the financial and emotional carnage, and parties to the agreement are more likely to honor and enforce what has been decided.
The Divorce Resource Center of Colorado is committed to changing the way our society divorces. We envision divorce to be a process that does not end with a Decree, but one that is a catalyst for change that leads to new beginnings. Our goal is to provide resources that will empower clients in each and every step of their journey through the difficult life transition of divorce and beyond.