Early-Withdrawal Penalties Don’t Apply on 401(k) Money in Divorce

Q: As part of my divorce settlement, I will soon receive about $35,000 from my wife’s 401(k) plan, which will equalize our respective contributions to these plans. Will any penalties for premature withdrawal be levied on these funds? Does anything prevent me from spending the money or from putting it into a tax-sheltered account of my own?

--S.T.A.

A: Distributions from 401(k) plans made pursuant to a “qualified domestic relations order” are exempt from the penalties--10% federal and 2.5% California state--normally applied to premature withdrawals (those made before age 59 1/2) from tax-deferred savings plans.

However, if you elect to spend the money and those funds were contributed on a pretax basis, you would be required to pay taxes on that amount, as you would on any withdrawal of tax-deferred savings. If you elect instead to continue saving the money on a tax-deferred basis, you may roll your distribution from your ex-wife’s savings plan over into an individual retirement account of your own without penalty or immediate tax obligation.

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Q: A friend has an interesting way of giving money to her elderly parents, and I am thinking of copying it. Each year she puts $20,000 into her parents’ brokerage account as a gift ($10,000 to each parent). The stock generates some welcome dividend income for them, and because her parents are in a low tax bracket, the income is not eaten up by taxes. Because she, like me, is an only child, she will eventually inherit their respective estates. So she will essentially get back everything she gave, plus appreciation. And because neither set of parents has a large estate, estate taxes shouldn’t be an issue for either of us. Is there anything about this plan that I’m missing, or is it as sound as it seems?

--A.S.Q.

A: Your plan passes muster with our experts, with a few caveats.

First, let’s explain why the experts like your strategy: By giving your parents cash that can be used to purchase an appreciable asset, you stand to inherit securities investments whose tax basis will be stepped up upon the death of your parents. This means that the cash you give them can grow through appreciating stock investments without generating a tax liability for you. Further, because your parents are in a low tax bracket, they can take maximum advantage of the dividends that these investments generate over the course of their lives.

Now let’s discuss the potential pitfalls. First, you should be sure that the total value of your parents’ estate does not exceed the federal limits on the amount that can be passed on to heirs free of estate taxes. You should also be aware that your parents are under no obligation to leave their estate to you. If there is any indication that they are under such an obligation, your annual donations into their brokerage account can be deemed to be an incomplete gift.

Finally, you should (especially after last week’s wild ride on Wall Street) realize that any money invested in the stock market or other securities is not completely secure; not only could the account not grow, but the principal could be at risk.

Your parents are also free to use the proceeds in the account as they wish over the course of their lifetimes. The money could be needed for medical expenses or other emergencies--or maybe a trip around the world! Remember, if you have truly made a gift of the funds, you have no say over how they are used.

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Q: I know that we must pay estimated taxes on capital gains by the end of the quarter in which they are accrued. However, must we still do this if there are offsetting capital losses from other transactions? Why can’t we just wait until filing our tax returns to show the offsetting transactions?

--G.D.

A: The Internal Revenue Service says you may indeed follow the common-sense approach you have outlined here. There’s no need, a spokesman says, to pay taxes when you know you are only going to get back that money in a refund. However, be warned that a lapse in your math or an unexpected windfall could put you in danger of being penalized by the IRS for under-withholding.

Remember, the IRS wants you to prepay at the very least an amount equal to your previous year’s tax bill or 90% of your current year’s obligation. Failure to do so incurs a penalty. If you haven’t done so already, now is the time to get your affairs in order.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com