I’m getting $285,000 from my ex-spouse’s 401(k). I want to pay my children’s credit-card debt and student loans. Will I have to pay tax?

Am I able to gift them this money without having to be taxed to death?

Tax-Planning Parent

Dear Parent,

After the ordeal of divorce, here’s some good news. You can help your kids, but there will be taxes to be paid along the way. 

In 2023, you can give gifts up to $17,000 per recipient before the gift tax applies. (The gift tax exclusion is pegged for inflation so the upper limit on the exemption may increase from year to year. Stay tuned for what the amount will be in 2024.)

But let’s just suppose you already have the cash on hand.

You could knock out the $7,000 in student loans for one child. You could also erase $17,000 of the $18,000 credit card bill. In the following year, you pay off the remaining balance.

Another option: if your child with the credit-card debt is married, you could give the remainder to his or her spouse, said Luis Rosa, founder of Build a Better Financial Future in Pasadena, Calif.

Children’s debts vs. retirement

The bigger question is whether you ought to use the money to pay your children’s debts, or focus on your own retirement needs.

“This is money that’s earmarked for retirement,” said Rob Seltzer of Seltzer Business Management in Los Angeles, Calif. “Your kids can borrow for a house or get some other debt consolidation for credit-card debt. You can’t borrow for your retirement.”

Scott Bishop, partner and managing director at Presidio Wealth Partners in Houston, Texas, recommends you explore a qualified domestic relations order. 

A QDRO directs a retirement plan to make a payment to a spouse or former spouse to pay child support, alimony or marital property rights (which includes cash, securities, bank and retirement accounts and  pensions acquired during the marriage).

Withdrawal penalties before age 59 ½

If the $285,000 worth of QDRO money went straight into your IRA, you would not pay taxes on it now, Bishop said. The money would grow with deferred taxation. 

Of course, the tax rules would kick in when you withdraw from the IRA in retirement, but by then you could likely be in a lower tax bracket by yourself.

But if you use $25,000 to help your children get debt-free, that money will be subject to income tax right now, Bishop said.

As a general rule, 401(k) distributions under a QDRO skip the 10% early-withdrawal penalty for people under age 59 ½. If you are under that age, however, check with a professional whether the 10% early withdrawal penalty would apply on that $25,000.

Once the money from your divorce settlement hits your IRA, any withdrawals under age 59 ½, would trigger the 10% early-withdrawal penalty, according to Rosa.

Long-term retirement planning

However, think carefully about how you want to spend this 401(k) money.

“Not only are you getting taxed on the money, you are forfeiting your opportunity for that money to grow tax free for years,” said Michael Stutman, a matrimonial attorney and partner at Alter Wolff Foley & Stutman in New York. He called the money originating from your ex’s 401(k) “a source of last resort,” Stutman said.

Bishop agrees. If you want to do this, use money that’s sitting in a bank or brokerage account.

You have to ask yourself about the message you’re sending your children, Bishop said.

“You don’t want to enable your child to make future bad decisions by alleviating bad past financial decisions,” he said.

I can empathize with the urge to help your kids as a caring parent. I don’t know the backstory to your family and/or how hard your children have worked to get to where they are, but money decisions can also be useful life lessons.

Got a tax question? Write me at: [email protected]

Thanks for reading. I want to help you think more broadly about the issues that affect your taxes. I’m not offering tax advice, just an attempt to look at what the swirl of tax rules and economic conditions could mean for your wallet.

I’m here for the reader who faces their taxes with an air of resignation. You’re just not that into taxes, I get it. I was once that guy. Underneath the jargon, think of your taxes like a maze — with money at the end. Or a trap that you need to avoid.