Raiding Your 401(K) Can Be a Divorce Disaster

Many divorcing spouses find themselves strapped for money to pay for mounting legal bills and the higher costs of supporting two households, rather than one. With bank accounts and brokerage accounts drained to zero, some look to tap their employer 401(k)s or IRAs for quick cash to cover these costs. Within a few days, you can have the balance of your retirement account, or even just a small portion, deposited into your checking account. It’s so easy! What could possibly go wrong?

In fact, direct withdrawals from a 401(k) or IRA can be financially disastrous. Retirement savings are meant to remain in place until you reach retirement age, and the government has put in a tax system that penalizes those who raid their accounts early. If you take money out, Uncle Sam will be knocking on your door, come tax time, and if you happen to be below age 59½, the government will include an additional penalty totaling 10% of the amount withdrawn.

Sheryl’s Costly Mistake

Most Americans have no idea of the financial ramifications of taking money out of retirement early. For example, Sheryl, from New York City, felt like she had no choice but to take money out of her 401(k). Her contentious divorce had been going on for over a year, and her husband had reached a new low — no longer contributing his paycheck to their joint account that Sheryl used for everyday expenses for herself and their three kids. She discovered this at the Whole Foods checkout counter when she swiped her debit card and it was denied. The checking account was drained. Sheryl’s small teacher’s salary could not stretch enough to keep the family afloat, and she felt forced to use the only account left in her name, her retirement account.

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Sheryl’s situation is not as uncommon as you might think, and unbeknownst to her, she would run into another roadblock making this more complicated than she had imagined. According to Alan Feigenbaum, a partner at Alter, Wolff & Foley LLP, the law requires the adverse party’s written consent, or a court order, to withdraw funds from a retirement account during a divorce action. Known as the “Automatic Orders,” this statute provides for a safe harbor that permits transfers/disposal of property while a divorce action is pending “in the usual course of business” for “customary and usual household expenses” and “reasonable attorney’s fees” in connection with the divorce action — except in the specific case of retirement accounts. If, in the context of divorce litigation, you are contemplating the removal of funds from a retirement account, Feigenbaum suggests that you discuss this issue with your attorney.

Not having access to this information, Sheryl withdrew $100,000 from her 401(k) to pay rent and everyday expenses for the kids. Unfortunately, the IRS took its fair share of federal, state and local taxes, which depending on your state of residence, could total to roughly $40,000. On top of this whopping tax bill, she was required to pay an additional IRS penalty of 10%, which added another $10,000 to her bill, leaving Sheryl with only $50,000, or half of what she was counting on to support her family.

What She Could Have Done Instead

If Sheryl could have a do-over and had gone to a financial professional, they would have suggested that she investigate whether she could take out a loan against her 401(k). There are no long application forms or credit checks needed to get this type of loan, and money can be deposited into your checking account within days.

The amount of a loan usually starts at about $1,000 and maxes out at the lesser of half your vested account balance or $50,000. Instead of the scenario, above, that left Sheryl with $50,000 after taking out double that amount, she could have taken out a loan for only $50,000 and walked away with that full amount and favorable repayment terms. While interest rates vary by plan, most common is prime rate plus 1%, which is very low, and much cheaper than credit card rates.

401(k) loans must typically be repaid within five years, often on a monthly schedule. Usually, you repay directly out of your paycheck, and some plans allow you to reimburse the account all at once, with no penalty. This would have allowed Sheryl to repay the borrowed amount as soon as her lawyer was able to file a motion for temporary support.

Still, There Are Some Downsides

While a 401(k) loan would have been a much better option for Sheryl, it does have downsides. Sheryl would lose out on the growth her loan money would have made if it had stayed in the 401(k) account. And while Sheryl does not plan to quit her job, and is one of the most well-respected teachers in her school, if she lost her job (quit, changed jobs, got laid off) while she had an outstanding 401(k) loan, the entire loan balance would be due, typically, within 60 days.

While those are good reasons to think twice before taking out a 401(k) loan, the biggest and least understood negative of borrowing from your retirement account is the double taxation of the dollars you use to repay your loan. If Sheryl makes a normal contribution to a 401(k) from her paycheck, she does so with pre-tax dollars. This means that for every dollar she contributes to her 401(k), Sheryl protects a dollar of earnings from taxes, reducing her tax bill at the end of the year. Essentially, the money Sheryl contributes to her retirement account is never taxed until she, eventually, takes it out. This is one of the major pluses of participating in a 401(k) plan.

However, Sheryl’s loan repayments would be made with after-tax dollars, so she would lose the tax break. What's worse, when Sheryl eventually retires and starts taking money out of her retirement account, all of her 401(k) money, both the regular contributions and the loan repayments she made, would be taxed at the highest ordinary income tax bracket. That means Sheryl’s loan repayments would be taxed twice: first at repayment, while she would be working hard to pay off this debt, and once again at retirement, when she would need to withdraw the money to cover costs in her golden years. This double income taxation makes 401(k) loans very expensive!

The Bottom Line

The biggest takeaway here is to speak with your lawyer about how best to protect yourself, financially, during a divorce, or, if one is anticipated, taking into consideration the restrictions imposed by the Automatic Orders. Resorting to using credit cards or tapping retirement accounts can leave you financially vulnerable and set your savings back for years. It’s important to have the appropriate professionals helping you to put in place the right strategy for you.