“HELP!!!I need this money NOW but I have no idea how much I should take now that it’s finally coming to me!”
This was the desperate cry of two of my closest friends over the last 3 months.
One a teacher and the other a doctor, both women who as part of their divorce settlements, had portions of their ex-spouses retirement plans coming to them.
Generally, distributions made from a Defined Benefit Contribution Plan before age 59 ½ is considered an ‘early distribution’ and would be subject to a 10% penalty.
One of the exceptions to this rule is allowing money to be taken out of a qualified plan in accordance with a written divorce instrument called a QDRO and distributed to an ex-spouse.
The recipient can spend any/all of the qualified money without paying the 10% penalty.
However, the distribution is still subject to ordinary income tax so the amount taken will be added to the recipients W-2 earnings or other earnings being reported on their tax return in the year the distribution is taken.
Things To Consider
What is your ‘cash position after the divorce?
Will you need to pay off debt?
This could be possible credit cards, or money borrowed to get the divorce or debt that you are also splitting up with your soon to be ex?
Do you need a new automobile because you relinquished your’s in the negotiations (like I did) OR because your’s has 180,000 miles on it and you know it will cost more to keep that vehicle financially than to purchase more reliable transportation now.
Your living where?
Will you be relinquishing the home or moving into a new apartment? Will there be moving expenses? Will you need a down payment needed for a new home?
Will you be required to pay for college expenses for the children?
In the above scenario, I had one friend who was now single with no kids and would be filing her taxes as ‘single’.
The other was now a single mom with two teen boys with one headed off to college in just two years and would be filing “head of household’ on her taxes.
AlertBoth of these women had moved out of the marital home before the divorce.
Both were interested in purchasing homes and planning on using part of the funds as a down payment.
The challenge was in figuring out what was “needed” along with what would be received and how that would impact them from a tax stand-point to ensure that the amount they requested as ‘cash out’ was actually received.
It’s important to understand that in addition to the withdrawal being added to your income for tax purposes, when a distribution is made to the recipient, the plan administrator must automatically withhold 20% for income taxes and send you only the difference.
So if you NEED $30,000 and request that amount, you will only be getting $24,000 after the plan administrator keeps the 20%. Michelle Jacobik
If you realize this after the fact and don’t have enough say for the downpayment on the home your are looking to purchase and need to take more any further distributions will have the 10% penalty on them.
You must also keep in mind that you are now in a new tax bracket and the amount of the distribution, once ordinary taxes are applied will reduce the amount you received by the taxes you will now owe.
You must be very careful and strategic about when/how much you take to meet your goals.
One friend was planning on taking the distribution in November but not closing on her new home until January.
This meant that she had NO itemized deductions from the home (interest, real estate taxes) to offset the distribution because the events happened in two separate tax filing years.
My other friend, knew she was receiving a big bonus and raise in January so guiding her to take the distribution in November made more sense from a taxation standpoint than her waiting.
Most importantly was that both of these women had an amount in their heads that they were going to use and roll the rest into their own retirement accounts.
However, when I had the chance to review with them the ‘bigger picture’:
Both were very off on their true financial need versus their fairy tale need.
Both took advantage of this ‘one time’ penalty free distribution in an amount much higher than what they had anticipated originally.
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