There are a lot of reasons why you might want to lay your hands on some cash when you're going through a divorce. Unfortunately, divorce isn't on the list of circumstances under which the Internal Revenue Service will waive penalties if you cash out your IRA early. Cashing out a retirement asset can complicate your divorce proceedings as well.
Taxes and Penalties
If you cash out your IRA before your divorce is final, you'll likely be liable for a 10 percent penalty and you must pay income tax on the distribution. You can dodge both these bullets if you transfer the money to your spouse incident to your divorce, but there's a catch – your divorce decree must provide for the transfer and you won’t have a decree until your divorce is over. IRAs don’t require qualified domestic relations orders – known as QDROs – to achieve tax-free, penalty-free treatment, but the money must leave your account as a transfer, not a distribution. In other words, you must give it to your ex pursuant to your divorce decree's terms; it must end up in an account in her name. The retirement account remains a retirement account, and neither you nor your ex may use the money for other purposes.
The IRS offers a short list of circumstances that might allow you to avoid the 10 percent premature distribution penalty, although you must still pay taxes on the distributed income. If your cash crunch has come about because your divorce has affected other financial responsibilities, you can cash in a portion of your IRA if you qualify for one of these penalty exemptions. They include using the money for medical bills or insurance, college tuition, or up to $10,000 to buy a home if you haven't owned a residence in the last two years. If you need money to pay your divorce lawyer but you are also faced with paying your child's tuition bill in the next few months, you can use your available cash toward your divorce, then take an IRA distribution for the tuition.
Equal Periodic Payments
Another option is to take substantially equal periodic payments instead of cashing out your IRA. This is a tricky equation, so you may want to speak with a tax professional first. It involves taking incremental withdrawals from your IRA for a period of five years or until you turn 59½, whichever happens first. You can begin the distributions in the year you are divorcing if you're in dire need of cash. You won't have to pay the 10 percent penalty, but you'll have to include the money on your tax return as income.
The IRA as Marital Property
Another important consideration is that contributions made to your IRA during your marriage, as well as its earnings during that time, are marital property. This portion of the investment is subject to division in your divorce. If your IRA is worth $200,000, but it was worth $50,000 when you got married, you may be required to share $150,000 with your spouse. If you live in a community property state, the court will split it 50-50, but in all other states, assets are divided according to the principles of equitable distribution. This means the judge will divide the account in a way that seems fair. Assuming a 50-50 split, the most you can take from your IRA if you're willing to pay the taxes and the 10 percent penalty is $125,000 – your original $50,000 plus half of the balance. If you take the full $200,000, you'll find yourself in the position of owing your spouse $75,000 – her share of the marital portion – when your divorce is final. The judge can order that you reimburse her in cash or give her other marital property of equal value.