One of the best things about building a retirement or pension plan is that you don't incur any tax liability as it grows. Of course, you will have to pay taxes once you start drawing on it when you reach retirement age, but in the meantime, you can accumulate as much money as possible for the days when you stop working.
That is, unless you get a divorce. Your spouse may be entitled to a portion of your retirement plan. This puts you in jeopardy of paying the tax penalty for an early withdrawal when you transfer the agreed upon or ordered amount to your ex-spouse.
Is there a way to avoid the penalty?
Fortunately, the IRS understands that people get divorced and end up dividing their assets, including retirement plans. You can avoid paying the early withdrawal penalty by obtaining a qualified domestic relations order as part of your divorce settlement. This document allows you to add your former spouse as an alternate payee on your retirement account. IRAs require a different process.
In order to keep you from incurring unnecessary tax liability, the QDRO must meet ERISA and federal government requirements. It must also be approved and entered as an order by the court. To meet ERISA requirements, it must contain the following information:
- Plan owner and alternate payee mailing address and name
- Number of payments and how they will be made
- Percentage allocated to the alternate payee and how you derived that percentage
It may also be a good idea to talk to the plan administrator prior to spending the time and money to obtain a QDRO. The plan may require specific language or provisions without which you will not be able to take advantage of making the transfer of funds without penalty. Even though you could obtain a form from your plan administrator, it may not quite fit your circumstances. It may be better to use the form as a guide to create your own document that fits your needs.
Taxes may still apply
The spouse receiving the funds from a retirement will owe taxes on it at some point. Only the penalty does not apply. If you are the one receiving the funds, you may want to explore all of your options and the tax ramifications and benefits that come with each choice prior to making a decision.
Why go through all this trouble?
First, no one likes to pay more in taxes than is necessary. Beyond that, 10 percent may not seem like much, but actually, it is. For example, if you receive $100,000 from your spouse's retirement plan, 10 percent comes to $10,000. What could you do with $10,000?