When you own a 401k plan, you are technically investing in a trust account that is qualified by the Employee Retirement Income Security Act (ERISA). ERISA specifies how these retirement accounts are to be operated and how money may be contributed and withdrawn. This has important implications for transferring money to a spouse. If you do not do this properly, you could end up paying a penalty to the IRS.
The designation of a 401k as a trust account qualified under ERISA is significant. A fiduciary is charged with managing your 401k plan and the assets in it. Even though you may contribute money to your 401k plan, and you can choose mutual funds or other investments inside the plan, there is a plan administrator that holds the money in trust for you until your retirement. Because of this arrangement, your account benefits are not transferable to another individual.
The limitations on assignment of benefits is actually a good thing. It protects you from having your retirement savings taken as a result of your filing for bankruptcy, your financial institution going bankrupt or a creditor coming after you for money that you owe.
There are exceptions to the rules governing assignable benefits in a 401k. A court may issue a qualified domestic relations order (QDRO) to override ERISA rules. A QDRO must be issued by a judge before any benefits can be transferred. A judge normally issues a QDRO in divorce cases, when the court finds it necessary to split up retirement assets to support the other spouse who otherwise would not receive any benefits for retirement or in cases when the support of a minor child is involved.
If a judge has not issued the order, then all distributions and transfers will be considered taxable distributions. If you are under the age of 59 1/2, then the distribution will be subject to a penalty of 10 percent as well. There is no way to get around this rule. Additionally, once a QDRO has been issued, the plan administrator for your 401k must comply.