Circumventing Early Withdrawl Tax Penalty On Retirement Benefits

by Milandria King, LL.M, of Cordell & Cordell, PC

Couples who find themselves in divorce proceedings may realize that in this economic climate, they are in need of more cash than is available to them. There is often an ongoing need for more cash flow following a divorce than one’s salary or maintenance payments may provide. The financial shortfall may operate to suspend negotiations regarding settlement, and this may prove to substantially reduce available funds.

Some divorcing couples have retirement assets which may help alleviate cash flow issues. Sometimes couples may be skeptical to use these assets for pre-retirement needs since most are of the mindset that these assets should be reserved solely for retirement purposes. This may be contributed, in large part, to concerns regarding distributions from retirement funds prior to age 59 and the resulting ten percent penalty tax.

 

This penalty tax may be avoided as there are four methods for receiving distributions from retirement accounts prior to age 59 without the fear of incurring the ten percent penalty tax for early withdrawal.  These methods may be employed by divorcing couples in order to take advantage of settlement options which may otherwise remain unexplored.

In general, the laws addressing retirement assets provide that taking a distribution from retirement assets before age 59 will result in a 10% penalty tax.  The methods discussed below, when properly implemented, assist in the avoidance of the 10% penalty tax levied for early withdrawal.  It must be noted, however, that funds withdrawn from a retirement account will be taxed as income the year those funds are withdrawn.  

The first method relates to section 72(t) of the tax code.  This section states that the 10% penalty tax will not be applied to funds withdrawn from a retirement account if the money is in substantially equal periodic payments (SEPP).  IRA assets are eligible for section 72(t) treatment, but 401(k) assets are eligible only if the plan participant is no longer employed with the sponsoring employer.  

Taxpayers must comply with certain rules in order to avoid the penalty tax and/or interest fees. The IRS has provided in its regulations, that periodic payments include at least one payment per year, as a bare minimum. In addition, the plan participant must take payments for five years or until the participant/member is 59 years of age, whichever period is later.  Once the designated period has expired, the owner may elect to change the payment amount or stop receiving payments.

The SEPPs may be determined by different methods developed by the IRS.  In general, each method will yield a different amount and the owner may choose the one which supports their particular situation. As a caveat, the amount should not be set unreasonably high because, should the account not earn enough to maintain the periodic payment, the account may become depleted. This would mean the participant failed to comply with the five year requirement. Ultimately, this would cause a realization of otherwise eluded taxes, penalties, and interest.   

Another method for avoiding the 10% penalty is to annuitize an IRA. Pursuant to this method, the owner remits a sum of money to an insurance carrier in exchange for a payment, which is guaranteed, over a specified period of time.  The duration requirement is met when the annuitant selects a payout period that will span a number of years or, in the alternative, for as long as he or she lives. With these immediate annuities, the payment amount is fixed, thus, the SEPP requirement is met. Given the current economic climate, this method makes sense because the risk of investment is transferred to the insurance company which is obligated to transfer the required payment to the annuitant.

As a general rule, money cannot be withdrawn from most employer sponsored retirement plans while the employee is still employed there. The third method, known as a Qualified Domestic Relations Order (QDRO) is an exception to this general rule.  A QDRO may be used in order to transfer funds from the 401(k) of the participant to the alternate payee’s IRA.  When the money is transferred to the IRA, it is subject to the tax-deferral benefits of a traditional IRA.

The tax code also provides that money being transferred pursuant to a QDRO may be received by the recipient spouse (i.e., alternate payee) without incurring the 10% penalty tax.  By utilizing a QDRO, the recipient will receive a lump sum of money which can be used towards the payment of bills such as college tuition, legal fees, and a down payment for a house. Further, by utilizing a QDRO, the available funds in a 401k may be split with some of the money being transferred to the spouse’s IRA and the remainder being given to the spouse.  As a caveat, any funds that are transferred directly to the spouse may not later be transferred into the spouse’s IRA, with the exception of the annual IRA contribution limit.

QDROs may be used only with employer-sponsored retirement plans and are not available for use with an IRA. Please bear in mind that not all employer-sponsored retirement plans will allow the use of a QDRO. For example, some plans will not permit lump sum payments while others are addressed by a different section of the tax code.  

A final method for use in avoidance of the 10% penalty applies to employees who leave an employer after they are 55 years of age. The tax code allows these individuals to forego the age 59 rule and start receiving distributions from a 401(k) without the worry of the 10% early withdrawal penalty. In order to properly take advantage of this method, the employee must truly have separated from service. The employee may not continue to work for the sponsoring employer, even without compensation, and utilize this method.

In general, it is always prudent for clients to keep their assets sheltered from tax assessments for as long as possible.  In addition, should the retirement accounts be completely depleted by use of some of these methods, the client may find a shortfall of assets in retirement years without the luxury of time during which to replenish those accounts. Every client should discuss the above referenced options with his or her attorney prior to taking a distribution. Legal counsel will assist a client in assessing the benefits and consequences of these methods.  

Milandria King is a Senior Attorney in the Memphis, Tennessee office for Cordell & Cordell, P.C., admitted to practice law in the state of Tennessee. Additionally, Ms. King is admitted to practice before the Sixth Circuit Court of Appeals and before the United States District Court for the Western District of Tennessee. Her memberships include the American Bar Association, the Memphis Bar Association, the Tennessee Bar Association, as well as the Association for Women Attorneys.

Read more about Ms. King.

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