When couples divorce, assets are usually divided. However, that asset split doesn’t automatically extend to retirement plans. This is where a qualified domestic relations order (QDRO) can come into play. A QDRO is a court order used to divide the assets that are in specific types of retirement plans, including 403(b) and qualified plans, such as 401(k)s. But if you want to use that money, for example, to buy a house, there are several points to consider first.
The Early Distribution Penalty
Assets distributed from a qualified plan under a QDRO are exempt from the usual 10% early-withdrawal penalty. So, if you are under age 59½ and want to use any portion of these assets immediately, you may not want to roll over that portion of the assets to an IRA. Funds rolled over to a traditional IRA are then distributed from that IRA are subject to the 10% penalty, unless you meet an exception.
If you're not going to use all of the money right away, you could have a portion of the amount processed as a direct rollover to your traditional IRA and the balance paid to you. The amount that is processed as a direct rollover to your IRA will not be subject to withholding tax.
Because the qualified plan assets you receive under a QDRO are rollover-eligible, amounts that are paid directly to you instead of to an eligible retirement plan will be subject to mandatory withholding. This withholding is 20% for federal taxes and an additional amount for state taxes depending on where you live. Therefore, you may want to ask for an increase in the distribution amount to ensure that the net amount you receive is enough to buy your new home.
Several qualified plans will not distribute assets under a QDRO until the plan participant—in this case, your former spouse—experiences a triggering event, such as reaching retirement age or being separated from service with an employer. Others consider the QDRO a triggering event.
Distributions May Be Taken Over a Certain Period
Unless you need some of the money immediately, you may choose to roll over the assets to your traditional IRA and have the distributions paid to you over time. Amounts paid to you for at least five years or until you are age 59½—whichever is longer—are exempt from the 10% early-distribution penalty, provided the payments meet certain requirements. This is commonly referred to as substantially equal periodic payments or 72(t) distributions. If you end up considering this option, make sure you know how much you'll be getting each year.
Converting the Assets to a Roth IRA
If you want to convert the assets to a Roth IRA, you must first roll over the funds to a traditional IRA. The funds can then be converted from the traditional IRA to the Roth IRA. However, you should know that you will owe taxes on the converted amount for the year the conversion occurs.
The Bottom Line
Don't assume that retirement account assets roll up into your divorce settlement. These assets need to be addressed separately. Be sure to carefully consider how and when you'd like to be able to use these funds since a mistake could result in unwanted tax penalties. Also, if the retirement plan is a qualified plan make sure you know whether there are any distribution limitations.