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Can divorcing couples avoid taxes and penalties for 401(k)s?

On Behalf of | Mar 25, 2024 | Property Division

The longer a marriage lasts, the more property people acquire together. They often use some of their income to prepare for the future. Many couples in Hawaii make contributions to 401(k)s or similar tax-sheltered retirement accounts for decades. Funding an account gives someone resources to rely on during retirement and reduces their taxable income at the time of the contribution.

People can easily accrue hundreds of thousands of dollars or more in retirement savings accounts during their marriages. They may then have to address those assets when they decide to divorce. Even if the retirement account is in the name of one’s spouse, a 401(k) may be part of the marital estate for property division purposes.

If someone must divide a 401(k) during their divorce, do they have to worry about income taxes and large penalties?

There is a way to avoid penalties

Most people understand that they cannot take money out of a 401(k) before retirement without serious repercussions. The financial consequences of making an early withdrawal from a 401k can be significant. Any amount that someone withdraws contributes toward their income that year, which can affect their income tax obligations. Additionally, withdrawals made before retirement age are subject to a penalty. The standard penalty for early withdrawals is 10% of the amount taken from the account prematurely.

When discussing splitting in the account with a spouse, that might mean 10% of half of the balance accrued during the marriage lost just to penalties. Thankfully, spouses don’t have to worry about covering that penalty if they follow the right procedure for dividing a 401(k) as part of the property division proceedings in a divorce.

The proper use of a qualified domestic relations order (QDRO) eliminates the 10% penalty and tax consequences of removing funds from a 401(k) account. To be eligible for a QDRO, couples must have a property division order that requires the division of the account. Therefore, the actual division of the retirement account typically does not occur until after the completion of the divorce proceedings.

Understanding the financial implications of asset division choices may benefit those preparing for a divorce. Spouses often want to prioritize the preservation of high-value assets, such as retirement savings, as they strategize for divorce.

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