When someone’s 401(k) interest is divided in a divorce, neither party must suffer a tax consequence or an early withdrawal penalty. The funds from the 401(k) transferred from one spouse to the other may be rolled over, without consequence, provided that the rollover is completed within sixty days. For example, if spouse A receives $50,000 from spouse B’s 401(k) account pursuant to the terms of the divorce, spouse A may park the funds in a generic bank account temporarily — for instance, while spouse A sets up a new account — but the funds must land in a proper, tax-qualified account within sixty days of the date the funds left spouse B’s 401(k) account.
The receiving spouse may opt against rolling over the funds into a tax-qualified account without paying the early-withdrawal penalty. But the transfer does count as a taxable event during the tax year that the transfer occurs, so the receiving spouse needs to plan accordingly. That is, the receiving spouse would be wise to pay estimated taxes on the transfer.
When someone liquidates funds from an IRA (individual retirement account) before age 59 1/2, there is a ten percent penalty. However, when an IRA is divided between spouses in a divorce, the transfer of funds incident to the divorce are not subject to the early-withdrawal penalty. In order to avoid the penalty, the receiving spouse must roll over the funds into an IRA or other tax-qualified account within sixty days.
The manner in which the 401(k) interest is divided is a court order called a Qualified Domestic Relations Order (QDRO). The QDRO contains terms that direct the plan administrator in the proper division of the 401(k) account. A QDRO is NOT USED for an IRA transfer. The banks handling an IRA transfer may have specific requirements, such as specific account information for the destination of the transferred funds; but for the IRA transfer, a QDRO is unnecessary.