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Need Access to Cash After Your Divorce?

Need Access to Cash After Your Divorce?

August 11, 2021
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Oh no! Money got tight after your divorce, and you’re still learning what your expenses will look like now. I get it. You’re not alone, many people experience this same need for liquid cash.  Unfortunately, that’s not often something many divorcees have on-hand, perhaps due to legal fees or increased expenses. Like most Americans, your largest asset (aside from your home) is likely your retirement plan, but those are untouchable unless you’re over 59 ½ or older- right? Well, maybe.

In general, some IRAs and most employer-sponsored retirement plans have a few ways you can access funds on a penalty-free basis before you reach age 59 ½.  Let’s go through them one by one.

I’ll start with perhaps the least-known withdrawal option, which only applies to 401k, 457 or 403bs, NOT an IRA. If your divorce awarded you a portion, or all, of your ex’s employer sponsored retirement plan (401k, 457, or 403b) you may be able to make a penalty-free withdrawal, regardless of your age. This is allowable as long as two stipulations are met: 1) The retirement plan must have been split due to a QDRO (Qualified Domestic Relations Order, or QDRO, for short. Often pronounced QUA-droh or Q-DROH), which is a judgment, decree, or order, including an approval of a property settlement agreement as a result of divorce. 2) The penalty-free withdrawal is limited to the very first withdrawal. This applies for partial rollovers, too. If you plan to split the proceeds from one of these accounts in the form of a partial-rollover, note that there is an order of operations that must be followed. If you first move assets to another account in your name, then subsequently plan to make a withdrawal, your withdrawal will be penalized. In this case make sure you take the withdrawal out prior to transferring anything to an IRA so you avoid the 10% penalty.3 As you can see, there are a few potential hang-ups, so it’s important that you know and apply the rules.

Unfortunately not all qualified plans allow for QDRO-related withdrawals until the plan participant (your ex) experiences a triggering event such as reaching age 59 1/2 or separates from service. 4 Regardless, this is a good place to start so check with the plan administrator to find out if it’s a viable source for a withdrawal.

Another great option is to look at your retirement plans that aren’t connected to an employer. Specifically speaking, do you have a Roth IRA? It’s important to distinguish if your IRA is a Traditional or a Roth IRA as this next strategy only applies to Roths. Roth IRAs differ from Traditional IRAs in that the contributions are made with already-taxed dollars (whereas Traditional IRAs are made with pre-tax dollars, and therefore are tax-deductible at contribution). In general, IRA rules state that penalty-free withdrawals can be made once you reach age 59 ½, but, Roth IRAs offer a few additional penalty-free withdrawal options. Roth IRAs allow for contributions (also known as the principal) to be withdrawn tax and penalty-free at any time. You can see this play out in the following example. Let’s say your Roth IRA is currently worth $50,000 and $20,000 of that was money you contributed over the years. You are able to withdraw up to $20,000 both tax and penalty-free! Roths also allow for penalty-free withdrawals of the growth for a few select expenses: first-time home purchase, medical expenses or college expenses.5 Be sure to understand the fine print on these withdrawals: penalty-free withdrawals are only allowable after the account has been established for 5 years, and withdrawals of growth are only penalty-free, not tax-free.

Let’s dig into the first-time home purchase option for Roth IRAs just a bit more because you might be surprised to find out you qualify for this! Roth IRAs allow up to $10,000 to be withdrawn penalty-free (not tax-free)for a first-time home purchase. You might think this doesn’t apply to you if you’ve already owned a home, but that’s not entirely true! According to IRC § 72(t)(8)(D)(i), a “first-time homebuyer” is an individual with no present ownership interest in a principal residence for two years before acquiring the principal residence for which the distribution was made. 2 This is a great option for you if you’ve never taken advantage of this feature in the past. But, if you have, just know that each taxpayer has a maximum lifetime exception limit of $10,000, so be careful not to exceed that lifetime limit. 2

Now, another more hidden option is available to people at least age 55 and separated from service. If you’re at least age 55 and leave your employer you can make a penalty-free withdrawal from a 401(k) or 403(b) plan. Similar to IRAs, this would be a taxable event, but you are able to access the monies without a 10% early withdrawal penalty, which can be a valuable option. The rules specifically state the withdrawal is only an eligible withdrawal if separation from service was on or after the attainment of age 55; for those with public safety jobs (such as police officers or firefighters), the early withdrawal age is lowered down to 50. 2

Lastly, and perhaps the most restrictive option, is to enact a Series of Substantially Equal Periodic Payments (SSEPP) from a retirement plan. A Series of Substantially Equal Periodic Payments is a plan where distributions are made at least annually for the life of the taxpayer, and the 10% early withdrawal penalty is avoided. 2 The payments may begin anytime with a few exceptions that first require the employee to separate from service. 2 The reason this is placed last in the list is because it isn’t a one-time strategy. It requires the taxpayer to turn on a spigot of income that will continue to be paid throughout their lifetime. So even when you reach age 59 ½, when most plans allow you to make penalty-free withdrawals, you will be stuck continuing to receive income from this program same as you had been prior to reaching age 59 ½. That also means you can’t access the investment any faster than your scheduled payments. I think of this option much like a pension. Once the pension payments begin, you’re unable to make any changes or dip into your pool of money, you just get the scheduled payment.

This list is not designed to give blanket-advice because every case is different, and general advice cannot be made appropriately in hopes of benefiting every person’s situation. That’s why working with a professional who specializes in Divorce cases is so critical, as it ensures you don’t miss out on any potential options or inadvertently get yourself into a blunder (whether it be due to taxes, penalties, or long-term opportunity costs). Regardless of where you are in your divorce, there is likely some point you will find yourself needing access to your assets. Of course, if you’re able, consulting with a Financial Planner before, or even during the divorce process, will help you take best advantage of your assets. From your time together you will fill your quiver with valuable strategies and solutions that not only help you guide your negotiations but also will follow all the rules.

 

1 IRS Code Section 72(t)(2)(c) “Retirement Topics- QDRO- Qualified Domestic Relations Order”. IRS.gov. 13 October 2020.

2 Nelson, Brent W. “Retirement Account Freebies: Taking Penalty-Free Withdrawals”.  AmericanBar.org. 23 March 2021.

3 Guillen, Lina. “Divorce Settlement Blunders- Seven Costly Financial Mistakes”. Divorcenet.com. 24 March 2021.

4 Segal, Troy. “Using QDRO Money From a Divorce to Pay For a New Home”. Investopedia.com. 27 February 2020.

5 Schwab.com. “Roth IRA Withdrawal Rules”. 15 July 2021.

 

Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. You may want to consult a legal or tax advisor regarding any legal or tax information as it related to your personal circumstances. CRN-3711247-081021