The Right Way to Split an IRA

Ad­vi­sors are in the unique po­si­tion to help re­mind clients how tax rules work when an in­di­vid­ual re­tire­ment ac­count is split in a di­vorce.

Financial Planning - - CONTENT - By Ed Slott

Ad­vi­sors are in a unique po­si­tion to re­mind clients how tax rules work when an IRA is split in a di­vorce.

DI­VORCE OF­TEN IN­VOLVES THE SPLIT­TING OF ma­jor fi­nan­cial as­sets, and an IRA plan is, in some cases, a cou­ple’s largest sin­gle as­set.

Split­ting an IRA in a di­vorce is not like split­ting a home or other as­sets. IRAS con­tain their own spe­cific tax rules that must be fol­lowed to avoid trig­ger­ing taxes or penal­ties. Ad­vi­sors are in the unique po­si­tion to help di­vorc­ing clients en­sure IRA funds are split cor­rectly.

A re­cent U.S. Tax Court case is a re­minder for both ad­vi­sors and clients of how tax rules work when an IRA is split in a di­vorce. De­spite an agree­ment and good in­ten­tions, the rules in this case were not fol­lowed, re­sult­ing in un­nec­es­sary taxes and penal­ties.

GOOD IN­TEN­TIONS, BAD RE­SULTS

When Jeremy and Karie Sum­mers de­cided to di­vorce, they were de­ter­mined to do so in the most am­i­ca­ble and least ex­pen­sive way pos­si­ble.

The Sum­mers did not want to in­volve lawyers. On their own, Jeremy and Karie put to­gether an agree­ment cov­er­ing how they would han­dle cus­tody of their four chil­dren and divide their prop­erty.

On March 18, 2013, Jeremy filed for di­vorce. His fil­ings in­cor­po­rated their agree­ment. Jeremy had an IRA, and he wanted to give half to Karie.

Karie did not work and had debts. To help her, Jeremy agreed to split the IRA be­fore the di­vorce de­cree be­came fi­nal. That was a crit­i­cal mis­take.

In late April 2013, Jeremy took a dis­tri­bu­tion of his en­tire IRA. He de­posited the $17,378 in the check­ing ac­count he shared with Karie. The next day, us­ing al­most half the funds, he paid off Karie’s car loan. He later trans­ferred an­other $71 to the check­ing ac­count to en­sure she re­ceived ex­actly half the IRA.

On June 3, 2013, a fi­nal di­vorce de­cree in­cor­po­rat­ing the agree­ments set forth in Jeremy’s di­vorce fil­ings was en­tered. How­ever, as he and Karie had al­ready di­vided up the IRA, the de­cree stated that nei­ther party had a re­tire­ment plan.

Jeremy filed his taxes for 2013 and paid the in­come taxes due on the IRA dis­tri­bu­tion. How­ever, he did not pay the 10% early dis­tri­bu­tion penalty. The IRS said he owed the penalty. He dis­agreed and went to court rep­re­sent­ing him­self. The court held that the 10% early dis­tri­bu­tion penalty ap­plied to the IRA dis­tri­bu­tion.

THE PENALTY DIS­PUTE

Jeremy con­ceded that he owed the 10% penalty on the half of the IRA dis­tri­bu­tion he kept for him­self. That left the court to de­cide whether the half he gave to Karie was sub­ject to the penalty.

Jeremy ar­gued he should not be held li­able for that por­tion. He made the case that the dis­tri­bu­tion was paid pur­suant to a qual­i­fied do­mes­tic re­la­tions or­der to an “al­ter­nate payee.” He said Karie was the al­ter­nate payee.

Un­for­tu­nately for Jeremy, the court sided with the IRS. In­ter­est­ingly, the IRS did not ar­gue, nor did the court say, that there was no way the ex­cep­tion to the 10% penalty for dis­tri­bu­tions pur­suant to a QDRO could ap­ply, be­cause QDROS

are only used for com­pany re­tire­ment plans, not IRAS.

EX­CEP­TION DE­NIED

In­stead, the court agreed with the IRS and said Jeremy did not qual­ify for the ex­cep­tion for two rea­sons.

First, the IRA dis­tri­bu­tion was made di­rectly to Jeremy and not to an al­ter­nate payee. He re­ceived the check and de­posited it into the joint bank ac­count. He then gave Karie half the pro­ceeds.

Second, there was no court or­der of any kind, much less a QDRO. Although Jeremy’s di­vorce fil­ings men­tioned a split of the IRA, a month be­fore the fi­nal court or­der was is­sued; he took a to­tal dis­tri­bu­tion of the IRA and gave half to Karie.

NO CHOICE

The fi­nal di­vorce de­cree de­clared nei­ther Jeremy nor Karie had a re­tire­ment plan, which was ac­cu­rate, be­cause the IRA had al­ready been dis­trib­uted. The IRA dis­tri­bu­tion was not made “pur­suant to” that or­der or any court or­der.

The court ex­pressed sym­pa­thy for Jeremy, but still held him li­able for the 10% early dis­tri­bu­tion penalty. Ac­cord­ing to the court, there was no choice.

LESSONS LEARNED

Here are three lessons that can be learned from Jeremy’s mis­for­tune.

1. A di­vorce de­cree is re­quired. For an IRA to be di­vided with­out trig­ger­ing a tax on the trans­fer there must be a di­vorce de­cree is­sued pur­suant to state do­mes­tic re­la­tions law that ad­dresses mar­i­tal prop­erty rights.

The di­vorce de­cree will usu­ally come from a court and may in­cor­po­rate or­ders from state agen­cies. With­out a di­vorce de­cree, there is no au­thor­ity for the IRA to be di­vided.

Some­times clients make the mis­take of think­ing a ca­sual agree­ment set­tling the di­vi­sion of their prop­erty with­out the in­volve­ment of a court is enough to divide an IRA. This is not the case.

The mere fact that a prop­erty set­tle­ment is agreed to and signed by the par­ties will not, in and of it­self, cause the agree­ment to be part of a di­vorce de­cree.

It is pos­si­ble, how­ever, for di­vorc­ing par­ties to agree to terms as to how IRAS should be di­vided, and then sub­mit the agree­ment to the court for ap­proval.

In this case, the tim­ing was wrong. To

Agree­ing to split an IRA be­fore a di­vorce de­cree be­came fi­nal was a crit­i­cal mis­take.

help out his soon-to-be ex-wife, Jeremy took a dis­tri­bu­tion be­fore the court is­sued the fi­nal di­vorce de­cree. The fi­nal di­vorce de­cree did not ad­dress any di­vi­sion of the IRA, be­cause the IRA had al­ready been dis­trib­uted to Jeremy.

2. QDROS do not ap­ply to IRAS. A QDRO is not used to divide IRAS, in­clud­ing SEP and SIM­PLE IRAS, in a di­vorce. A QDRO is a very spe­cific type of or­der that is re­quired to divide a com­pany plan sub­ject to ERISA in a di­vorce.

To qual­ify as a QDRO, a court must in­clude cer­tain de­tailed in­for­ma­tion in an or­der. Un­der fed­eral law, the ad­min­is­tra­tor of the com­pany plan is re­spon­si­ble for de­ter­min­ing whether the re­quire­ments to be a QDRO are met.

3. There is no ex­cep­tion to the 10% penalty for an IRA dis­tri­bu­tion due to di­vorce. When com­pany plan funds are di­vided un­der a QDRO and paid out from the plan to the al­ter­nate payee, there is an ex­cep­tion to the 10% penalty.

Dis­tri­bu­tions from an IRA that is prop­erly di­vided af­ter a di­vorce are still sub­ject to the 10% penalty.

Jeremy took an IRA dis­tri­bu­tion be­fore his di­vorce was fi­nal. He did not take a dis­tri­bu­tion from a plan pur­suant to a QDRO, so he could not es­cape the 10% penalty.

THE RIGHT WAY TO DO IT

The cor­rect way to divide IRA funds that are in com­pli­ance with a di­vorce de­cree is to per­form a trustee-to-trustee trans­fer (a di­rect trans­fer) of the IRA funds, mov­ing them di­rectly from one spouse’s IRA to the other spouse’s ac­count.

If the trans­fer is done cor­rectly, the IRA will be split and there will be no tax li­a­bil­ity for ei­ther spouse. That’s what should have been done here.

Be­fore a trustee-to-trustee trans­fer is set in mo­tion, ad­vi­sors will want to re­view the di­vorce de­cree care­fully and with the fol­low­ing points in mind.

A di­vorce de­cree man­dat­ing di­vi­sion of an IRA is a court or­der re­quir­ing the IRA owner to act, not the IRA cus­to­dian. The di­vorce de­cree will or­der the IRA owner to take the nec­es­sary steps to divide the IRA. It is not the IRA cus­to­dian but the IRA owner who will be in trou­ble with the court if the re­quired ac­tions are not taken. The di­vorce de­cree should be spe­cific about how and when as­sets are split. If the IRA is in­vested in as­sets that fluc­tu­ate in value, the date that the IRA is di­vided may be crit­i­cal.

The di­vorce de­cree should clearly state who is re­spon­si­ble for any fees and how they are paid.

If a di­vorce de­cree is un­clear on any of these mat­ters, an ad­vi­sor may con­sider ask­ing the court for more clar­i­fi­ca­tion. In rare cir­cum­stances, a di­vorce de­cree may need to be re­vised.

Don’t as­sume your client’s di­vorce at­tor­ney is well-versed in how IRAS should be han­dled in a di­vorce. This is a very spe­cial­ized area.

AF­TER THE TRANS­FER

Af­ter the trans­fer due to di­vorce, if the funds re­main in an IRA, there would con­tinue to be no tax con­se­quences. How­ever, if the spouse who re­ceives the funds de­cides to take a dis­tri­bu­tion from his or her IRA, that dis­tri­bu­tion would be tax­able.

If the spouse who takes the dis­tri­bu­tion is un­der age 59½, the 10% early dis­tri­bu­tion penalty would also ap­ply.

Although the funds were trans­ferred due to di­vorce and may even have been dis­trib­uted to pay costs as­so­ci­ated with the di­vorce, there is no ex­cep­tion to the 10% penalty here.

A spouse who is awarded IRA funds re­sult­ing from a di­vorce may also con­vert those funds to a Roth IRA.

Be a proac­tive plan­ner and guide your clients through this process. They will avoid un­wanted taxes and penal­ties, and see the value you’ve pro­vided when they most needed the fi­nan­cial help.

When com­pany plan funds are di­vided un­der a QDRO and paid out from the plan to the al­ter­nate payee, there is an ex­cep­tion to the 10% penalty.

Ed Slott, a CPA in Rockville Cen­tre, New York, is a Fi­nan­cial Plan­ning con­tribut­ing writer and an IRA dis­tri­bu­tion ex­pert, pro­fes­sional speaker and au­thor of sev­eral books on IRAS. Fol­low him on Twit­ter at @thes­lot­tre­port.

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