Charles and Natalie Braun were in their mid-forties with two children, ages 10 and 12, living in the suburbs of Boston. They had a comfortable 3-bedroom home; they had 2 cars in the garage; their children were attending school in a community that prided itself on its schools and community facilities.
Everything seemed fine; that is until it wasn’t.
Charles told Natalie he was not happy, that they had grown apart, and that they no longer had common interests. In short, he wanted a divorce. Natalie suggested marital counseling, “after all,” she protested, “she had not known that they had grown apart.” Charles said it was too late. He wanted a divorce, but a nice divorce. And so that is the backdrop for what led Charles and Natalie to divorce mediation.
Charles and Natalie wanted their children to remain in their community and continue to attend the same schools. They agreed that the children should be in their joint physical and legal custody, having two residences. Yet, there was only one house and not enough in savings to buy another house in the same community or even nearby.
They thought of selling the house and each buying two smaller, more modest homes, but giving up their three percent mortgage and buying two houses with mortgages that had skyrocketed over seven percent was daunting. They were stuck. They did not have access to family resources where they could borrow money. They did not anticipate anything but cost-of-living increases in income; they did not anticipate receiving assets of any kind, unless they won the lottery.
And so, Charles and Natalie thought of the seemingly unthinkable access to funds—retirement holdings.
They knew that retirement holdings could be transferred, after divorce, from one spouse to the other without any tax ramifications if they were kept in retirement holdings. They did not know that funds from one spouse’s 40lk (or 403b) could, by a Qualified Domestic Relations Order (QDRO), be retained as a lump sum without evoking the ten percent early withdrawal IRS penalty. They welcomed the information as the route to securing funds for Charles to use as a down payment on a home.
Yes, he would owe taxes on the money, since taxes have never been paid, but the waiver of the penalty made the withdrawal more attractive. Yes, he would have a mortgage with a high interest rate. Yet even with these financial drawbacks, the money would allow him and Natalie to stay in the same community and provide the children with stability of home, community, and schools. They were willing to live with the drawbacks.
Charles and Natalie agreed that they would keep the marital home under joint ownership for two years, hoping that the interest rates would go down. At the end of two years, Natalie would remortgage the house in her name. The retirement transfer from Natalie to Charles, adjusted for the tax impact, constituted a partial buyout of Charles’ interest in the marital home. The balance of the buyout would be paid with Natalie’s refinancing of the house in two years.
Clearly, there were “what ifs” and negatives in the couple’s plan. Interest rates may not decrease. The use of retirement funds constituted a loss of the deferred tax investment growth of the funds. They were purchasing another house in a “high” priced market with a high interest rate loan. Still, after all the negatives were weighed and the positives enumerated, they decided to move forward with their settlement.
Admittedly if Charles and Natalie had Roth IRA funds, they would have been able to draw the amount of their contribution without any tax consequences—no early penalty and no taxes to be paid. However their retirement holdings were held in traditional IRA accounts and 401k plans. Traditional IRA(s) are not subject to QDRO(s) and can only be withdrawn before age 59-1/2 for a house purchase if they were building/buying a home for the first time. Without other alternatives, Charles and Natalie agreed to use retirement funds, taxable as they were, to move forward with their joint custody arrangement, in the same community, with two residences.