What are the Tax Implications?

Sometimes people who are going through divorce think that they can avoid preparing a QDRO to divide a defined contribution plan (like a 401(k)) simply by taking the money out of the plan and giving it to their soon to be ex-spouse.  When that happens, the Plan Participant will be taxed on the money they take out as it will be counted as income and taxed at normal income tax rates.  If the Participant is less than 59 1/2, then there will also be a 10% tax penalty.  The receiving spouse will pay no tax on the money they receive.

What happens when you transfer or receive the funds via a QDRO?

If you receive retirement funds pursuant to your divorce from your ex spouse, there should be no taxes on the transfer if you transfer the funds to an IRA or other qualified retirement plan.1040

If you are to receive a part of a defined contribution plan (eg 401(k)), once the Plan receives the Court-approved QDRO, the Plan will set up an account for you and transfer your portion of the funds into your account.  If you leave it there, or transfer it to an IRA or another similar retirement plan, then you will not pay any tax.

If you receive a check from the plan (and do not deposit it into a qualified retirement plan within 60 days), then you will be liable for income tax on the amount that you took out.  Normally the Plan will withhold 20% of what you request in cash for taxes, so if your intent is to roll over the entire amount, you need to be aware that your will actually receive only 80% of the funds requested (the rest will go to the IRS), unless you requested the Plan not to withhold any for taxes.

If you are under 59 1/2 and you take the cash and do not move it to a retirement fund, then you will be taxed income tax rates and will also be charged a 10% tax penalty. If you are over 59 1/2 or meet other special circumstances, you will not be charged the 10% penalty, but will have to pay tax on withdrawals.