People getting divorced often need more cash than is readily available. Many divorcing couples have substantial money saved in retirement accounts. But they are understandably are reluctant to withdraw from them to meet current financial needs. What if you need cash out?
A majority of retirement accounts are pre-tax accounts. This means any money you take out of the account will be subject to income tax. The withdrawal is taxable in the year it is withdrawn. It’s taxed just as if it were additional ordinary income. The financial institution holding the account will likely automatically withhold 20% of the withdrawal towards your tax liability.
Besides the income tax, there’s also generally a 10% penalty due to the IRS for making withdrawals from a retirement account prior to age 59½.
Let’s say you are in a 24% tax bracket and have to pay the 10% penalty on top. You would have to give Uncle Sam one of every three dollars that you withdraw.
Cash Out Strategies
So what are some strategies if you really need to get cash out of a retirement account?
- If possible, get a loan from your retirement account instead – which you can pay back over time.
- If you have a Roth IRA, consider withdrawing from it to avoid the income tax, although you may still have to pay the 10% penalty.
- Time the withdrawal(s) to occur in years in which your other taxable income is relatively low.
- Spread the withdrawals out over several years if this will keep you in a lower tax bracket.
Avoiding the 10% Penalty
The tax code provides ways to avoid the 10% penalty. Here are four of the most common:
- 1. Section 72(t)
- 2. Immediate annuity
- 3. QDRO transfer to a spouse
- 4. Age 55 separation from service
Section 72(t) of the tax code states that the 10% penalty won’t apply to money taken from a retirement account if the money is withdrawn in “substantially equal periodic payments” (SEPP). Any IRA assets are eligible for Section 72(t). 401(k) assets are eligible only if the account owner no longer works for that employer. There are rules that must be followed: 1) “periodic payments” means at least one payment per year; 2) you must take payments for five years or until you are 59, whichever period is longer and 3) you must use one of three methods of determining the “substantially equal” amount.
Annuitize the IRA. This is available for IRAs but not 401ks. With an immediate annuity, you give a lump sum of money (from an IRA) to an insurance company in exchange for guaranteed payments over a specified period of time.
QDRO transfer to a spouse. Usually, it’s advisable for a QDRO to transfer money from the employee spouse’s 401(k) to an IRA of the non-employee spouse. Such a transfer avoids all tax and penalties. However, the tax code allows 401(k) money transferred under a QDRO to go directly to the non-employee spouse without the 10% penalty. Normally the recipient spouse would deposit this money in a bank account. This method cannot be used for IRAs.
Age 55 separation from service. If an employee spouse leaves their employer after age 55, the tax code permits them to withdraw from their 401(k) without the 10% penalty.
A Certified Divorce Financial Analyst can help you understand all the financial and tax implications associated with divorce.