I am just divorced and am receiving 401K in a large sum. If I stay below $125,000 gross income will I stay at 25% tax penalty.

Are you receiving this as part of your divorce settlement? Not your own 401K? Do you need to use this money immediately? How old are you?

Yes my divorce settlement. It is getting transferred to my name. An IRA for $64,000. 401K at $220,000. I am 41 and a single mother of 4. My gross income at my job is $41,500. I purchased a home and have a mortgage of $270,000. My credit was ruined due to my ex-husband failing to pay a mortgage, car loan and electric bill for 4 months preceding the home loan I applied for. I have 8.75 interest rate on this mortgage and need to redo it now that I've established my credit again. I need to pay down this mortgage as low as possible but have heard that if I keep my gross income below $125,000 the tax penalty will be at 25%... if I were to cash the whole thing in at once the tax penalty would be more like 40% and in the end that would lose me about 46 grand more I'm thinking. I also have a personal loan I had to take out to support myself until this money came to me. I owe $38,000 on that now and want to pay that off completely.

I'm not quite sure about the rules when it comes to divorce transfers. Some of the other tax experts should help with that. Iif you do cash out, the amount you cash out will be added to your taxable income for the year and may push you into a higher bracket.

But I think you need to sit down and think this through better. Even if you do take out only $80K that still means you are tossing out $20K in taxes. You need to compare what you can earn on that money vs what the money you are borrowing costs you. An 8.75% mortgage is maybe about 2 points higher then you could get so your savings aren't going to be that significant. Plus the tax deductibility of the mortgage lowers the effective cost. This means, if you can earn a 7% or higher return on the money, you will wind up better off investing it.

I really think, under your circumstances, you would be better off leaving the money in IRA investments.

Like Scott, I would recommend that you not cash the 401(k), but roll it to your own IRA. Here's a web site that gives some good information on this, to avoid the 10% penalty for early withdrawal:

Splitting the Retirement Accounts (Marriage & Divorce: Personal Finance) | SmartMoney.com (http://www.smartmoney.com/divorce/splitting/index.cfm?story=splitting)

To answer your question directly - you may very well be in the 25% bracket if you keep your gross income below $125K (your salary plus the amount you withdraw from the 401k). However, don't forget that you will also have to pay a 10% early withdrawal penalty on top of that!

Couple of items:

YOU may not be on the hook for the taxes! It depends on how the distribution was handled by your ex-husband's legal team.

If they did it correctly (from your ex-husband's point of view), the distribution was done under the QDRO (for Qualified Domestic Relations Order) exception, which would mean the Form 1099-R will be issued in YOUR name as an alternate payee and you pay the income taxes (unless you roll the money over into a rollover IRA; more on that later).

If they botched it (and that happens much more often than you would think), then your husband pays the income taxes because the Form 1099-R is issued in HIS name, which is the default position of the IRA and 401K custodian and probably CANNOT be changed once the distribution is made.

A call to your divorce attorney should get you a straight answer on this issue. If he/she does not know, have him/her FIND OUT, as it affects your follow-on decisions!

Now, if the money was issued in your husband's name, then, for you, it is TAX-FREE income to you, and you are free to spend it however you want.

If it was issued in your name, you should seriously consider doing a rollover into a traditional IRA to avoid paying taxes at would be AT LEAST a 28% and probably more likely a 33% federal income tax rate, PLUS whatever your state income tax rate would be.

You do not have to worry about the 10% Early Withdrawal Penalty, as distributions to an alternate payee (i.e. YOU) fall under one of the exceptions for this 10% penalty. You WILL need to properly request that exception when you file your 2007 tax return, though.

For these reasons, RUN (do not walk! ) to a competent tax professional who can guide your through this difficult process. It may cost you a few hundred bucks in tax consultation fees, but proper advice at this point is worth its weight in GOLD!

Once you have the answer to WHO pays the taxes, I can do some modeling (for a small fee) as to what your tax bill would be under the various options. If you are interested, contact me at [email protected].