Fort Worth QDRO Attorney on the 10% Early Withdrawal Penalty

QDROs are a powerful tool in the property division in a Dallas or Fort Worth divorce. They allow a party to receive part of an employee’s retirement plan benefits (such as a 401k or defined benefit pension). Under the federal law that governs private retirement plans (ERISA) an employer generally may not take away or give part of an employee’s accrued benefit to another person. (This is known as ERISA’s anti-cutback rule.)

The exception is for a qualified domestic relations order (QDRO) that awards a portion of the employee’s benefit to a spouse, former spouse, child or other dependent of the plan participant. A QDRO divides the employee’s benefit and gives it to the alternate payee without creating a taxable distribution for the employee. The share received by the alternate payee is taxable to the alternate payee. The question often arises whether the alternate payee must also pay the 10% early withdrawal penalty for taking funds out of the 401k or other retirement plan. This post will address the rules that apply to the early withdrawal penalty and retirement benefits obtained through a QDRO in Bedford, Dallas and Fort Worth.

The taxation basics of ERISA-governed retirement benefits (and some others) in Dallas and Fort Worth, Texas

Retirement benefits accrued in an ERISA-governed plan are generally tax-deferred funds taxed upon distribution in which a 10% penalty may apply. ERISA-governed retirement plans include 401k, 403b, most defined benefit plans held by private employers or unions, ESOPs, money purchase pension plans and certain profit sharing plans. Non-government, private employers are likely to have their retirement plans subject to ERISA provisions. Some private employer plans are not ERISA plans although their benefits may be tax-advantaged.

These plans are often not subject to the same tax rules as 401ks and other more common retirement plans. IRAs suffer the 10% early withdrawal penalty with one exception. A special rule applies to SIMPLE IRAs that makes distributions subject to a 25% penalty if distribution occurs within the first two years of participation. Government plans (like 457 plans) are not subject to the 10% penalty except for funds rolled in from a source that is subject to the penalty. The majority of retirement benefits are divisible by a QDRO will be ERISA-governed 401ks, ESOPs and defined benefit pensions in which the following rules apply.

Tax-advantaged deferrals of wages to ERISA plans in Dallas-Fort Worth, Texas

The tax-advantaged status of ERISA plans allows the participant to defer wages and receive contributions from the employer that allows money to go into the plan by deferring some or all of the taxes that would apply in a non-tax-advantaged account. The vast majority of employee deferrals are pre-tax that allows the employee to direct wages into the plan without paying taxes. These funds, as plan rules allow, grow without paying taxes on the gains that accrue.

When the funds exit the plan untaxed, they suffer taxes as ordinary income in the year distributed. That is, unless the funds roll over into another tax-advantaged retirement account or plan. Rollovers continue the tax-deferred status of the funds until the funds are distributed as a taxable distribution to the owner. Employer contributions, no matter the plan type, are always pre-tax and taxed as ordinary income.

After-tax deferrals of wages in ERISA plans

Some plans permit after-tax deferrals from the employee under two different schemes that adjust the taxation of distributions. Under the basic after-tax scheme employees pay taxes on deferrals but the funds go into the plan and grow tax-deferred. The earnings above the deferrals plus employer contributions are all pre-tax. The pre-tax funds are taxable as ordinary income. Deferrals suffer taxation only once.

A newer scheme allows after-tax contributions under the Roth rules. Roth deferrals work like other after-tax contributions (although subject to pre-tax deferral limits) but carry a tax advantage. If deferrals remain for five years and distribution occurs after age 59 1/2 then earnings are tax free. (Any employer contributions made along with the Roth deferrals are still pre-tax.) If a distribution does not meet these rules then the deferrals are after-tax but earnings are taxable.

The 10% Early Withdrawal Penalty on ERISA Retirement Plans in Dallas and Fort Worth

Any distribution of pre-tax funds from a qualified retirement plan (an ERISA-governed plan) or an IRA suffers a 10% early withdrawal penalty if made before the owner is 59 1/2 years of age or another exception under Internal Revenue Code section 72 applies. The 10% penalty applies to the full pre-tax amount and is in addition to the ordinary income taxes also owed. Several exceptions exist under section 72. Many exceptions are well known while a very important exception for QDRO funds is generally a mystery.

QDROs in Texas and the 10% Early Withdrawal Penalty

Retirement funds obtained through a QDRO do not incur a 10% early withdrawal penalty so long as the funds are paid as a taxable distribution from the plan in which the QDRO applies directly to the alternate payee. (Internal Revenue Code section 72(t)(2)(C) ) This rule is barely known even among financial advisers and divorce attorneys, who frequently deal with QDROs and QDRO funds. In my pre-attorney days working at a major retirement plan service provider, we frequently fielded calls from financial advisers who were clueless about this exception. Many times they were mad because the alternate payee had talked to our service associates and learned about the exception. The advisers were mad.

Here’s why it made them angry. The exception only applies on a taxable distribution from the plan in which the QDRO applies. If the money rolls over then the penalty will apply to any future taxable distribution. (Unless some other exception applies.) The advisers want to roll over that money into an IRA because to get paid. (Many advisers make their money taking a cut of assets brought in.) Reinstating a penalty that otherwise would not exist is not in the best interests of the client. The adviser likely should not recommend the rollover if the alternate payee might need those funds before age 59 1/2.

Planning Property Divisions in a Texas Divorce with QDROs

The alternate payee does not pay the 10% early withdrawal penalty if the alternate payee cashes out after the divorce. The bad news is that it’s still taxable as ordinary income to the alternate payee. If the sum is substantial it could have the effect of creating an unexpectedly large tax bill for the year. Cashing out and the tax consequences are among the reasons the divorce should contemplate financial needs and goals.

Property division in a divorce is not just about cutting everything in half. That can create new financial problems. Working with a certified financial planner and tax adviser can be extremely valuable in a divorce.

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