Can You Pull From 401(k) Without Penalty to Settle Divorce?

Before a married couple can divorce, they must settle the distribution of all their assets, including retirement plans. In addition to the emotional strain of divorce, a partner removing funds from a 401(k) retirement plan can suffer a taxable event, decreasing his retirement savings. Plan holders can avoid a penalty on 401(k) distributions if they take advantage of the legal system in their state.

A divorcing plan holder over the age of 59 1/2 will not owe a penalty on withdrawals. The IRS requires 401(k) plan holders under the age of 59 1/2 to pay a 10 percent penalty on all distributions from their retirement plan, except for hardship withdrawals. Since 401(k) plans are tax deferred and divorce does not qualify as a hardship for tax purposes, any divorcing plan holder, regardless of her age, can owe both a penalty and regular income tax on all withdrawals.

Private mediation agreements will require a plan holder to pay a penalty. In order to avoid a penalty when pulling money out of their 401(k) plan due to divorce, plan holders must have the state court that handles their divorce settlement issue a qualified domestic relations order (QDRO). This document tells an individual how and when he must divide communal property with his spouse, according to the U.S. Department of Labor.

In order for the federal government to consider a QDRO valid, the document must identify the name of the plan holder and his address, the name of the person he has to pay, the percent of the account each member of the couple gets to keep, the 401(k) account in question and the time frame of the plan transfer. If any of these elements are not in order, the individual’s plan manager will reject the QDRO, and the IRS will require the plan holder to pay a penalty, according to 401(k).

A 401(k) plan holder must provide the person who manages his plan with either the original or court certified copy of his QDRO document. The plan manager will then verify the authenticity of the QDRO, notify both divorcing parties of receipt of the document and hold ongoing 401(k) contributions in a separate account since they are no longer considered marital property. If the QDRO does not meet legal standards, federal law requires the plan manager to notify both parties that the document is not binding.

If a plan administrator approves the QDRO, he will make the transfer between the divorcing couple and will send the plan holder a 1099-R after the end of the tax year. This form should have distribution code 1 or J written on box 7, indicating a non-taxable and penalty free distribution, according to the IRS. If the 1099-R does not show either of these distribution codes, the plan holder must file IRS Form 5329 to claim an exemption from tax.