401(k) retirement plans are commonly divided in divorces by way of a Qualified Domestic Relations Order which prevents the transfer of the funds from the plan participants account to the other spouse from being a taxable event such as it would be if they simply withdrew money from the account. If you participate in a 401(k) plan then you are probably well aware that withdrawing money before you reach retirement age subjects you to a 10% penalty on the amount of money you withdrew and you have to pay income tax on the withdrawal.
For many divorce cases, however, the use of the 401(k) funds is a necessity for one or both of the parties. Recognizing the reality that people needed access to their accumulated retirement funds for legitimate and immediate financial purposes, the IRS created a mechanism for being able to utilize your 401(k) funds without having to pay the taxes or penalty on the withdrawals. A “hardship distribution” is defined by the IRS under Reg. § 1.401(k)-1(d)(3)(i) as an immediate and heavy financial need by the employee or the employee’s spouse or dependent with the withdrawal being a sufficient amount to satisfy the need.
The need to take a “hardship distribution” is not uncommon for many people involved in a divorce. Divorces can cause financial damage to both parties, but particularly the “dependent spouse” who may not have the cash flow or immediate resources to address an urgent financial need. It can also be a tool for the “independent spouse” who transferred a significant portion of their wealth to the other spouse. The award of 401(k) assets (if in the form of an IRA, the analysis changes somewhat) may be the financial resource they need to stabilize and rebuild their financial health. While any financial advisor would advise against using tax deferred money if it all possible, circumstances dictate otherwise at times and knowing this option exists may be helpful.
Aaron Weems is an attorney and editor of the Pennsylvania Family Law Blog. Aaron is a partner in Fox Rothschild’s Blue Bell, Pennsylvania office and practices throughout the greater Philadelphia region. Aaron can be reached at 610-397-7989; firstname.lastname@example.org, and on Twitter @AaronWeemsAtty.