The 401(k) Cash-Out Process
If you’re a married Texan who participates in a 401(k), 457 or other qualified retirement plan sponsored by your employer, whether you work for a private company or a federal, state, county or city agency, you and your spouse can free-up as much as 95% 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 your retirement plan are community property that are owned equally by you and your spouse. The Texas Family Code defines and codifies Texas community property law and specifically allows a married couple to divide all or any part of their community property into two separate property estates in whatever percentages they want. This is done by entering into a written agreement (a "partition agreement") that changes the classification of marital property from "our" community property to "his" and "her" separate property. Retirement plan benefits can be divided in this manner without changing any of the remaining community property assets of the marriage. Up to 95% of the retirement plan benefits can be changed into the separate property of your spouse and then withdrawn from the plan.
After you and your spouse sign the partition agreement, I will file a legal proceeding in a Texas state court asking the court to enter an order approving the division of the plan assets and directing the 401(k) plan administrator to divide those assets into two separate accounts in the percentages set forth in the partition agreement. (Let's assume 95% of the plan assets are being transferred to your spouse.)
The court signs the order and I forward it to the plan administrator for implementation. The administrator will then create a separate 401(k) account in the name of your spouse and transfer 95% of the plan assets into that account.
The money in your spouse's newly created account must then be removed from the 401(k) plan and that can be done in several ways: (1) Cash-out and pay income tax: The money can be cashed-out, which means it is paid directly to your spouse. The amount withdrawn will be included in your taxable income for the year of withdrawal. No 10% early withdrawal penalty will be assessed if your spouse is under 59½ years. The plan administrator will retain 20% of the amount withdrawn for federal withholding taxes. The amount withdrawn can be used for any purpose(s) you and your spouse choose. (2) Rollover and defer income tax. Alternatively, the money can be transferred (“rolled over”) to a self-directed IRA (new or existing) in your spouse's name 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 you and your spouse withdraw it. (3) Combination of cash-out and rollover. Depending on your income tax situation, you and your spouse could elect to cash-out some of the money and rollover the balance to an IRA.