ALBUQUERQUE, N.M. — Q: I have filed for divorce and have a tax question about my husband’s 401(k) plan. I am living in our house until we are able to sell. We will split all expenses of the house. I am considering several options to fund the purchase of a smaller home after our home sells. I could take my share of the proceeds and borrow the balance, or I could try to buy a new home for cash. For an all-cash purchase I will need additional money, and I have thought about cashing in some of the retirement plan. I understand that the money I take from the plan is taxable. But I am 43 and do not want to also pay the 10 percent penalty for being under age 59½. A divorced friend tells me that she thinks that penalty does not apply in a divorce but that I should check with a tax person. Is that true – can I avoid the 10 percent penalty?
The short answer is yes – you can avoid the 10 percent penalty for an early distribution. But there is a process that you need to follow, and your attorney should be able to help with that process.
The early withdrawal penalty applies to protect retirement plan assets for retirement. Qualified retirement plans, such as a 401(k), generally have additional protections such as plan restrictions on the ability to take money for nonretirement purposes.
There are, of course, exceptions to every rule. You need to make arrangements to qualify for receipt of some of the 401(k) plan assets and to avoid the penalty for a pre-59½ distribution.
First, you need the court to issue a qualified domestic relations order (QDRO) on your behalf as an alternate payee of the 401(k) plan assets. This is your husband’s retirement plan, so the QDRO will designate you as an alternate payee of plan assets.
If there is a certain amount that you want distributed to you now, the QDRO needs to designate this amount as currently payable to you. As you said, you will pay tax on the distribution. But amounts paid to you under a QDRO avoid the 10 percent early withdrawal penalty.
There are many exceptions to the 10 percent penalty, but they apply only if the requirements are strictly adhered to. Because the exception that you want to avail yourself of refers to a QDRO, you need to make sure that the distribution is pursuant to that order.
You will still need to complete the IRS Form 5329 that is used to compute the 10 percent penalty. Part I of that form reports the early distribution, but it also has a place (line 2) to show the amount exempt from the penalty. Line 2 also asks for a code for the exemption claimed, and a QDRO is coded “06.”
Q: In 2018, I allocated $2,400 to my employer’s flexible spending account for medical expenses. I had $655 left over at year end, and my employer tells me that the plan allows $500 to carry over to 2019 but that the $155 extra is forfeited to the plan. Are they allowed to take my money?
Yes. But your employer’s plan sounds very reasonable to me. Let me try to explain why you still have a pretty good deal out of the 2018 contribution that you made.
First, you avoided federal and state income taxes on $2,400 of income, and you avoided the Social Security payroll taxes on this amount. I don’t know your income level, but this may have saved you $800 or so.
Second, unused FSA funds must be forfeited because the plan cannot have the result of allowing you to defer compensation (avoid 2018 tax and get funds back in 2019).
Third, the employer’s plan can, but does not have to, either provide a 2½-month grace period after year end to spend unused money or allow you to carry forward as much as $500. Your employer’s plan does one of these.
The extra $155 can be returned to all plan participants on some reasonable basis, but the employer need not do so and it is generally too burdensome to do that. Plans often use excess funds to reduce administrative costs.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.