03 Sep Can my divorced daughter get her ex’s 401(k) funds tax-free?
Q. My daughter was recently divorced from her husband. She was awarded custody of her three small children. As part of the settlement, she was awarded half of her husband’s 401(k). She will be needing most or all of this money for a down payment on a house in which to raise her children. Is there any way for her to avoid paying tax on this money? She needs to put down as much as possible so she can afford the mortgage payments.
— Trying to help
A. This is a complicated situation that could have serious consequences for your daughter’s future.
First, your daughter’s divorce decree should contain terms providing for how her former husband’s 401(k) plan is, or was, to be divided upon their divorce.
“Assuming that such a provision exists and instructed her and her ex-husband to have a Qualified Domestic Relations Order (QDRO) prepared and facilitated to effectuate the division of this 401(k), then your daughter might now have her share of these funds in a similar eligible retirement plan in her individual name,” said Jeralyn Lawrence, a family law attorney with Lawrence Law in Watchung. “However, she will want to carefully consider how and when to utilize these funds since an early withdrawal could result in unwanted tax penalties.”
Generally, when the division and distribution of qualified retirement assets is incident to divorce and pursuant to a QDRO, the distribution is exempt from early withdrawal penalties, Lawrence said.
This means that when your daughter’s share of the 401(k) plan was established in a similarly eligible retirement plan in her individual name, her ex-husband was not obligated to pay early withdrawal fees on the amount transferred to your daughter, she said.
However, amounts drawn from your daughter’s share of the 401(k) plan that are paid directly to her will be subject to mandatory withholding, Lawrence said.
This withholding is 20% for federal taxes and an additional amount for state taxes depending on where she lives, she said.
The distribution will be treated as income to your daughter, unless some exemption applies, and she will be required to pay the appropriate tax on the income.
“Notably, many qualified plans will not distribute assets under a QDRO until the plan participant — in this case, your daughter’s ex-husband — experiences a triggering event such as reaching retirement age or he is separated from service with an employer,” she said. “Therefore, it is important that she consult with the plan and review the summary plan description provided to her.”
If your daughter isn’t sure what her divorce agreement allows, she should speak to an experienced family law attorney.
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This story was originally published on Sept. 3, 2021.
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