How to Avoid the 10% Early Withdrawal Penalty if Under Age 59 and a Half
The IRS wants the divorced spouse who is an Alternate Payee under a QDRO assignment of a qualified retirement plan to get a break from the income tax burden to help with a fresh start.
IRS Form 5329 instructions provide that the early withdrawal penalty will not be assessed on a cash withdrawal from a qualified retirement plan as long as the cash is taken from that plan. See the attached 2 page scan of the Form 5329 instructions.
However, this exemption does not apply to a cash withdrawal from an IRA. All IRA withdrawals will be subject to the 10% early withdrawal penalty unless some other exemption applies.
A frequent major mistake is that the Alternate Payee rolls a qualified retirement plan (like a 401(k) or 403(b)) into an IRA. They most often do it based on the advice from a financial product salesman who cannot earn commissions on retirement plan assets unless they are rolled over into an IRA.
That rollover to an IRA is a big mistake for two big reasons:
- Now the 10% early withdrawal penalty applies (which is a lot of wasted money); and
- The sales commission more than offsets any earnings on the IRA, thus the former Alternate Payee will lose money, consistently, year after year.
So, the Alternate Payee must put some major thought into what he or she will do with the new QDRO account. My best advice is to "invest" that money into cash equivalents within the retirement plan. All plans have a cash equivalent that will earn about the same or little more than a bank CD. Keep your money. Don't waste it.