How to Avoid the 10% Penalty When Taking Money From a Defined Contribution Plan

Normally, distributions made before a participant attains age 59 1/2 are called “early distributions” and are subject to a 10% penalty tax. The tax does not apply, though, 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. However, if an ex-spouse receives the 401(k) asset, there are some specific rules to be aware of.

Here is an example:

Sarah was married to an airline pilot who was nearing retirement. They were both age 55. There was $640,000 in his 401(k) and his 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 withdrew the funds.

Sarah’s attorney’s fees were $60,000, and she needed another $20,000 to fix her roof, so 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 401(k) goes into an IRA, which is not considered a qualified plan, Sarah would have been held to the early withdrawal rule. If she had said, “I need another $5,000 to buy a car,” it would have been too late. She would have had to pay the 10% penalty as well as the taxes on that money.

Rolling money over versus transferring money from a qualified plan:

The Unemployment Compensation Amendment Act (UCA), which took effect in January 1993, states that any monies taken out of a qualified plan or tax-sheltered annuity is subject to 20% withholding. However, 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! If you have questions regarding this issue or any other issues related to divorce, contact us.