Getting divorced is challenging enough without worrying about money, but did you know you can access your 401(k) to pay some bills? In this post I discuss why you might want to use a 401(k) to help pay for a divorce and how to use QDRO to do that.
There are many reasons why families in the midst of a divorce need quick access to cash. These reasons can include:
- One-time expenses related to the cost of divorce
- Making a down payment on a house
- Needing more money for expenses related to the divorce than your current salary provides
Why use your 401(k) to pay for your divorce?
The top reason to consider using your 401(k) to help pay for costs related to a divorce is that the lack of ready money can delay or even aggravate divorce settlement negotiations. Don’t let a lack of funds make a divorce or mediation harder than it has to be. Most of the time, one or both parties have enough money in their retirement accounts to fund the must-have’s of a divorce.
Reasons why people don’t tap their 401(k) to pay for a divorce include:
- Fear of the IRS, or engendering early withdrawal tax penalties. Divorce produces enough anxiety, it’s easy to understand why you wouldn’t want to add extra taxes to the mix.
- Lack of understanding or education. Most divorcing couples don’t understand the intricacies of their 401(k) account, so they adopt the mindset of “leave it be.” (Hint: Retirement accounts for both parties will likely be negotiated during divorce proceedings. That makes this an opportune time to determine if a withdrawal is the best course for you.)
- Concern that if they dig into their retirement, they won’t be able to recoup the loss in a timely manner.
- Their age. One or both parties are under 59 1/2. They believe they are too young to access the money.
Using a QDRO to get access to your 401(k)
The process for getting access to your 401(k) begins with a Qualified Domestic Relations Order otherwise known as a QDRO. Simply put, the QDRO (pronounced "cue-dro" or "qua-dro"), is a judicial order that splits a retirement or pension plan by recognizing joint marital ownership interests in the plan. A QDRO awards a portion of the plan’s benefit to an alternate payee; in this case, a spouse, former spouse, child or other dependent of the plan’s participant. So, essentially a QDRO makes it so that one spouse can transfer 401(k) funds to the other without incurring the penalty.
Getting a QRDO is a complicated process and not one for the do-it-yourself divorce crowd. QDROs must be done by a professional trained to prepare the QRDO documents. Keep in mind that funds transferred to the receiving spouse are taxable in the year the funds are received, unless invested directly into an IRA.
Potential problems with a QDRO include:
- Funds are not immediately accessible and can take upwards of six months or more from the date of dissolution.
- This rule does not apply to IRAs. Any premature distribution of an IRA related to a divorce would be subject to a 10% premature penalty.
- Any funds that are transferred directly to the receiving spouse cannot later be transferred into that spouse’s IRA (except for the annual IRA contribution limit that applies to everyone).
- Not all employer-sponsored retirement plans will qualify for this method. This is why you need to work with an experienced QDRO professional.
It is generally not considered sound financial planning to liquidate all or part of your retirement funds for purposes other than retirement. Whenever possible, I encourage my divorce clients to keep their assets sheltered from taxes for as long as possible. But if you need to pay for expenses related to a divorce and don’t have any other choice, it is possible to access your 401(k) with a QDRO.
There are significant pros and cons to using a QDRO and as stated above it’s definitely not a “do it yourself” kind of thing. I urge you to speak with both a divorce attorney or your financial advisor before you begin.