In a divorce, the assets that you have acquired during the marriage are shared and, in most cases, this means that one of you will transfer funds out of your name to the other’s name or that funds in joint names will be transferred to an account in a single name. This situation covers financial assets and real estate and businesses you may own.
The key to avoiding taxation on these transfers is to make sure that the correct procedures are followed. The tax authorities recognize that a divorce is merely a sharing of existing assets so they have established a set of rules to allow for a tax free transfer.
Financial assets have the most tax consequence so you need to follow the rules to avoid a tax issue in April. If you have a 401K you are transferring to your spouse, need to have a Qualified Domestic Relations Order (“QDRO” pronounced “quad-row”) and the correct forms from the financial institution holding the 401K. The QDRO is required under ERISA (“Employee Retirement Income Savings Act” – pension rules and regulation law) to give the pension company the authority to transfer the assets to an alternative party (your spouse).
The court will give you the QRDO and once received you fill out the forms from the financial institution the transfer can be done tax free. Sometimes the firm holding the assets may have a QDRO from they like to see so it pays to call and ask the question rather than have you attorney automatically draft the documents.
If you do not get a QRDO, and the appropriate forms, the pension plan will not likely transfer the money or, if they do agree to transfer, the funds there will be a tax consequence to the receiving party.
The transfer out of a 401k without the right documents will result in the receiving party being taxed on the gross amount of the funds transferred at their normal tax rate on income. In addition if the receiving party is younger than 59.5 years old, there will be a penalty associated with the withdrawal of 10%. Not a good result!
So while it may seem like a tiresome thing to do, getting the correct documents will result in funds getting to you tax free and you will not be facing a tax bill in April.
As always, if you need assistance with preparing for you divorce or structuring you property settlement agreement, reach out to set up a free consultation.