Do 401(k) withdrawals in divorce need reinvestment to be tax-free?

Question

I am currently going through a divorce, and my spouse plans to withdraw funds from my 401(k) to pay for her half of our house. Does that money need to be reinvested to avoid tax penalties?

James L. Arrasmith · Answer

In a divorce, funds from a 401(k) can be transferred to a spouse without triggering taxes or penalties, but it must be done through a Qualified Domestic Relations Order (QDRO). If your spouse plans to withdraw money directly from the 401(k) instead of rolling it into her own retirement account or handling it through a QDRO, she could face income tax on the withdrawal. However, if the distribution is made to her directly under a QDRO, she can receive the funds without the usual 10% early withdrawal penalty—even if she is under age 59½. 
 
That said, she will still owe regular income tax on any portion of the 401(k) she withdraws and uses, such as to pay for her half of the house, unless she rolls it into another qualified retirement account. Reinvestment into another retirement plan is only necessary to avoid paying taxes immediately; it’s not required to avoid the early withdrawal penalty if a QDRO is used correctly. 
 
If this process hasn’t been finalized yet, it’s important to ensure that the division of the 401(k) is included in the divorce agreement and processed properly with your plan administrator. Without a QDRO, the withdrawal could result in unnecessary tax consequences. It’s always best to handle this part of the divorce carefully to protect both parties from avoidable tax liabilities.

Q: Do 401(k) withdrawals in divorce need reinvestment to be tax-free?