You Can Avoid the 10% Early Withdrawal Penalty if the Distribution is From a QDRO Account
A good income tax break for divorcing couples is the opportunity for the Alternate Payee to take a distribution from a 401(k) account (and other qualified plan accounts) where that account was established pursuant to a Colorado divorce QDRO.
For example, Bill and Mary divorce. Bill transfers $20,000 from his 401(k) account to Mary, where the transfer is done pursuant to a QDRO signed by a Colorado Judge.
Mary can take a distribution of all or a portion from that new 401(k) account which was set up by the QDRO and avoid paying the 10% early withdrawal penalty.
However, Mary will have to pay income tax on the distribution (but not the 10% early withdrawal penalty.)
The key is to properly fill out IRS Form 5329, to avoid the 10% early withdrawal penalty. The instructions to IRS Form 5329 are scanned for your reference and download convenience.
A Common Income Tax Trap on a Similar Distribution
In the above example, Mary rolls her new $20,000 401(k) QDRO account into her own IRA. Then she takes a distribution from this new IRA.
In this case, she gets socked with the 10% early withdrawal penalty. The reason is that an IRA is not a qualified retirement plan and thus the IRA does not qualify for the penalty exclusion as provided on IRS Form 5329.
Instead, she should have taken the withdrawal from the 401(k) QDRO account.
Some Tax Professionals Question the Timing of the Distribution
Some tax advisors suggest that the distribution from the 401(k) should come directly from the plan administrator, before the 401(k) account is set up, in order to avoid the 10% early withdrawal penalty.
I disagree. Either way will work.
As I read the law, and as I read the instructions for IRS Form 5329, the distribution from the 401(k) QDRO account can be done after the account is set up and is done without the 10% penalty.
Anyway, if the Alternate Payee (Mary, in my example above) knows that she will take a distribution, then I draft the QDRO with the instruction to do an immediate distribution. (However, some plan administrators want the distribution to be done only after the new QDRO account is set up. Plan administrators differ on this.)