Avoiding the Excise Tax on Early Withdrawal Of Retirement Assets in Divorce

By Nancy Sachitano
Reproduced with the permission of the Bar Bulletin, published by the Maryland State Bar Association

Consider this scenario: You represent the wife in a divorce case; the parties have no children. They have reached a comprehensive settlement and have signed the appropriate agreement. The client is 36 years old and needs ready cash at the time of the divorce because she has debts to pay (maybe your fees). She has an Individual Retirement Account in her name and is entitled to $50,000.00 from her husband's 401(k) in connection with the settlement agreement. Your client asks you about taking one lump sum from her IRA to pay her debts. You should advise her that she will incur not only the income tax at ordinary rates on the withdrawal but a 10 percent early withdrawal excise tax if she takes a one time distribution from her IRA now. The income tax and early withdrawal tax make the withdrawal from the IRA an unattractive option; but the client still needs cash. If you know the finer points of the taxability of distributions from retirement assets in the context of divorce you know that your client has other options. If you don't know what they are keep reading.

A former spouse who receives a share of a participant's retirement benefit in an ERISA qualified plan is treated the same as the distributee of any payment made to the former spouse under a Qualified Domestic Relations Order or an order dividing a Federal Thrift Savings Plan. As a consequence, the former spouse is responsible for paying all taxes owed on the distribution from the plan at the time the funds are received.

To enforce the collection of income tax, the trustee of the retirement asset is required to withhold 20 percent on a direct distribution from a qualified retirement plan to a spouse or former spouse unless there is a direct transfer to an Individual Retirement Account or another qualified plan. (There are some distributions which are exempt from withholding requirement, such as distributions of any after-tax contributions to the plan). The recipient spouse can delay the imposition of the income tax and avoid the excise tax by a direct transfer (referred to as a rollover) to an IRA or other qualified plan of his or her choosing. Permissible transfers which will allow the former spouse to avoid the withholding include wire transfer, mailing or hand delivery of a check payable to the trustee of the retirement account for the benefit of the former spouse. Rollovers can be made into Individual Retirement Accounts, Individual Retirement Annuities, and qualified defined contribution plans.

To avoid the mandatory withholding and the 10 percent early withdrawal tax, it has become routine, perhaps rote, to advise a client to receive his or her share of the former spouse's retirement benefits by way of a direct rollover to an IRA. The standard advice to clients who are entitled to a share of their former spouses' retirement assets is having their share rolled directly into an IRA of their choosing, thereby avoiding the income and excise tax. But your client needs cash and soon. The advice which usually seems wise now can restrict your thinking and your client's options.

What you may not know is that the Internal Revenue Code permits a former spouse to receive a direct payment from a qualified retirement plan and avoid the 10 percent early withdrawal tax. A client who is entitled to a distribution from a Federal Thrift Savings Plan can also avoid the 10 percent early withdrawal tax by taking the distribution directly. This is a one-shot opportunity to avoid the 10 percent excise tax on the funds transferred from qualified plans or the Federal Thrift Savings Plan; however, this exception regarding the excise tax does not apply to transfers from IRA's. Once the funds are rolled over into an IRA, a distribution before the recipient reaches age 59 will result in the account holder incurring the income tax and the additional 10 percent early withdrawal tax. Knowing this, you are now in a position to advise the client of her ability to take direct payment of all, or part of, the funds to which she is entitled to from her husband's 401(k), bypassing her IRA. She will incur the income tax, but she will avoid the 10 percent excise tax. This is an important option many clients have and which they need to know. They can then make the decision that fits their current financial situation and long-term objectives.

Nancy Sachitano is the managing attorney and a member of Strickler, Sachitano & Hatfield, P.A., in Bethesda, Maryland. She concentrates her practice in family law.