The 401(k) Cash-Out Process
Whether you work for a private company or a federal, state, county or city agency, you and your spouse can free-up 100% of the money in that retirement plan to invest as you desire, either on a taxable or tax deferred basis, without paying the 10% early withdrawal penalty assessed on persons under 59½ years of age.
All benefits contributed and/or paid into a qualified retirement plan during a marriage are community property of the married spouses. The Texas Family Code allows a married couple to change the character of their marital property from community to separate by entering into a written agreement, called a partition agreement. Retirement plan benefits can be recharacterized in this manner without affecting any of the remaining community property assets of the marriage. As much as 100% of the retirement plan benefits can be changed into the separate property of the non-partiticpating spouse and then withdrawn from the plan.
A court order must be obtained approving the division of the plan assets and directing the 401(k) plan administrator to allocate those assets between the spouses as provided for in the partition agreement.
A certified copy of the court order is delivered to the plan administrator who then creates a separate account within the same plan in the name of the non-participating spouse and transfers the percentage of plan assets directed by the court into that new account.
The money transferred to the newly created spousal account can then be removed from the retirement plan and that can be done in several ways: (1) Cashing-out directly. The money can be withdrawn, just like a bank withdrawal. The plan administrator is required by federal law to retain 20% of the amount withdrawn for federal withholding taxes. The full amount withdrawn must be included in the married couple's taxable income for the year of withdrawal. No 10% early withdrawal penalty will be assessed if your spouse is under 59½ years. Once withdrawn, the money can be used for any purpose. (2) Rollover to an IRA. Alternatively, the money can be transferred (“rolled over”) to a self-directed IRA (new or existing) in the name of the non-participating spouse and invested from that account. No income tax is paid on the rollover, and no tax will be paid on earnings accumulated in the IRA until money is withdrawn. All earnings from investments made by this IRA account will remain in the IRA until your spouse withdraws it. (3) Combination of cash-out and rollover. Depending on the married couple's income tax situation, they could elect to cash-out some of the money and rollover the balance to an IRA.