Divorce isn't a pleasant undertaking. But at least you can minimize the tax fallout by taking a few key proactive steps.
Most importantly, make sure to set up a QDRO if you'll be splitting up qualified retirement accounts, such as 401(k)s. QDRO may sound like a creature from the latest Star Wars movie, but it actually stands for a "qualified domestic relations order." A QDRO can help you carve up the spoils of the marriage without any dire tax consequences.
A QDRO is a judgment or order that gives an "alternate payee"—usually, a former spouse—the right to receive all or a part of your benefits from a qualified retirement plan. You must make the QDRO pursuant to a state domestic relations order and relate to child support, alimony or other marital property rights.
If you don't have a QDRO in place, bad things can happen: The IRS treats plan distributions received by your ex-spouse as if they were paid to you, and then turned over to your ex. This means you get taxed on the distribution without any corresponding tax deduction for the transfer.
With a QDRO, the IRS taxes the distributions to the person receiving the benefits, not to you. Payments under a QDRO are exempt from the usual 10 percent penalty tax on withdrawals made prior to age 591/2.
If you're on the receiving end of a QDRO payment, you can avoid any current tax liability by rolling over the payout to an IRA in your own name. That enables you to maintain greater control over the funds and spread out future distributions to cut down the overall tax. (Minimum distributions must begin after you reach 70 1/2.) It also severs ties with your ex-spouse.
Rule of thumb: If you're under age 591/2 and need some cash, take a distribution now to avoid the 10 percent penalty on that amount. Then roll over the rest tax-free into an IRA set up in your name.