Posted by: Gary M. Sigman, CPA, MTax, PFS
We all know people who have gone through a divorce, and many readers have, no doubt, gone through it themselves. The emotional trauma suffered by all affected goes without saying. Unfortunately, in addition to the difficult personal issues the process entails, several issues need to be addressed to ensure that the division of retirement plan or IRA assets is properly made.
When divorcing spouses divide property, including cash, it is generally a tax-free transaction. This holds true before the divorce, when it’s finalized, and afterwards, if such property transfer is made incident to the divorce. However, this rule does not apply when it comes to retirement plan or IRA assets. Special attention must be paid when these types of assets are split in a divorce.
A spouse's qualified retirement plan assets (i.e., Keogh, 401(k), Profit Sharing, and Defined Benefit Plan accounts) are often part of a property settlement. When this is the case, the commonly preferred method to handle the split of such benefits is through a "qualified domestic relations order (QDRO)." A QDRO gives one spouse the right to share in the retirement benefits of the other and assesses the resulting taxes to the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them, even though they are paid to the other spouse. This would be treated as a taxable distribution to the transferee spouse. The 10% premature withdrawal penalty may also apply if such spouse is under age 59 ½. In addition, the recipient ex-spouse is treated as receiving a tax-free transfer of cash, which means that a tax-free rollover of these funds to an IRA is not a possibility.
A QDRO, which is contained within the divorce documents, must include specific wording, including:
- The name and address of both parties.
- The name of the retirement plan account to be split.
- The amount or percentage of benefits to be paid to the recipient from each account.
- The time period under which benefits are to be paid, and numbers of payments to be made.
While a QDRO isn't required to split up an IRA, special care must be taken to avoid unfavorable tax consequences. For example, if an IRA owner were to cash out his IRA and then pay his ex-spouse her share of the IRA, as stipulated in a divorce decree, the transaction could be treated as a taxable distribution (possibly also triggering penalties if under age 59 1/2), for which the IRA owner would be solely responsible. However, the taxes and penalties can be avoided, if specific IRS-approved methods for transferring the IRA from one spouse to the other are used. For example, money can be transferred, tax-free, from one spouse's IRA to the other spouse's IRA in a trustee-to-trustee transfer, as long as the transfer is required by a divorce decree or separation agreement. Special wording must be utilized in these documents for these tax-favored rules to apply. Also, the transfer shouldn't take place before the divorce or separation is final, or it may be treated as a taxable distribution. These rules also hold true for Roth IRAs, SEP accounts and Simple IRAs, since these retirement assets are types of IRAs for these purposes.
As you can see, it is important to retain an attorney who is experienced in this area. This is true, in particular, if the assets contained in the retirement plan or IRA are high in value. Don’t take chances with what may be your most valuable asset.
If you have questions about this or any other tax or financial issue, please contact one of the tax professionals at Zinner & Co.
