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.
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.
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.
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.
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.