Paying Taxes On A 401k Divorce Settlement In Illinois

The point of a 401(k), 403(b) or other tax-deferred account is to save money before paying taxes on the money saved.

If a worker saves 7% of their income in a 401(k) account, the worker will only be taxed, the year of that contribution, on the remaining 93%.

The money saved in a 401(k) grows over the years. Eventually, that saved 401(k) money must be taxed when the money is finally withdrawn. That is why 401(k) accounts are referred to as tax-deferred accounts.

When you are old and retired, you are not earning a regular income so you will be in a lower tax bracket during those years. The taxes on the withdrawals when you are retired will be minimal.

But, if you need to withdraw the money from a 401(k) before retirement age, the taxes must be paid on that 401(k) money as if it were income AND there will be a 10% penalty.

“If any taxpayer receives any amount from a qualified retirement plan…the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.” 26 U.S.C. 72(t)

When a 401(k) is divided between two spouses in an Illinois divorce does either spouse have to pay the taxes and penalties at the moment of distribution to the other spouse?

If the parties to the divorce use a Qualified Domestic Relations Order (QDRO), there will be no immediate taxes or pre-payment penalty when dividing a 401(k).

“The term “qualified domestic relations order” means a domestic relations order—

which creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to a participant under a plan” 26 U.S. Code § 414(p)(1)(a), ERISA § 206(d)(3)(B)(i)

The QDRO creates a separate 401(k) for the other spouse. This preserves the tax-deferred status of the money so there will be no taxes owed on the transfer of a 401(k) or a portion of a 401(k) pursuant to a divorce.

Other retirement accounts labelled as Individual Retirement Accounts (IRAs) will also be free from taxes if transferred pursuant to divorce.

“The transfer of an individual’s interest in an individual retirement account or an individual retirement annuity to his spouse or former spouse under a divorce or separation instrument…is not to be considered a taxable transfer made by such individual” 26 U.S. Code § 408(d)(6)

There is a general rule that there should never be tax on any divorce settlement amount.

“No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)…a former spouse, but only if the transfer is incident to the divorce.” 26 U.S. Code § 1041(a)(2)

Divorce lawyers are not tax experts. Divorce lawyers frequently require their clients to consult with their accountant or a lawyer who specializes in the preservation of tax-deferred retirement accounts status. I refer my clients to attorney Anne Schmidt to ensure that all tax-deferred accounts are properly treated post-divorce in order to avoid immediate tax obligations for all parties.

Rather than handling the tax treatment of a 401(k), I simply provide the directions in the Marital Settlement Agreement as to how a 401(k) should be divided. For help in dividing a retirement plan in your Illinois divorce, contact my Chicago, Illinois family law firm to schedule a free consultation with an experienced Illinois divorce attorney.

source https://rdklegal.com/paying-taxes-on-a-401k-divorce-settlement-in-illinois/