Split­ting Up IRAS Care­fully

There are only two ways to trans­fer IRA as­sets tax free in a di­vorce pro­ceed­ing in or­der to avoid a costly af­ter­math.

Financial Planning - - Contents - BY ED SLOTT

There are only two ways to trans­fer IRA as­sets tax free in a di­vorce pro­ceed­ing in or­der to avoid a costly af­ter­math.

Di­vorces are of­ten messy, as was the case for Michi­gan doc­tor John Kirk­patrick. Dr. Kirk­patrick sep­a­rated from his wife, Chris­tiana, in 2012, but six years later, found him­self in Tax Court after he failed to pay taxes on $140,000 in IRA dis­tri­bu­tions he with­drew to trans­fer to his ex.

Re­cently, in his case, the Tax Court re­minded us that there are only two ways to make a tax-free trans­fer of IRA as­sets in a di­vorce pro­ceed­ing. One way is to change the name of the IRA to the ex-spouse. The other way is to di­rectly trans­fer IRA as­sets to an IRA owned by the ex-spouse.

What you can­not do, how­ever, is take a dis­tri­bu­tion from the IRA and trans­fer those funds to a checking ac­count. That mis­take is what ended up cost­ing Dr. Kirk­patrick.

This is an im­por­tant re­minder that after a di­vorce de­cree is care­fully re­viewed, ad­vi­sors need to as­sist in trans­fer­ring IRA funds to com­ply with the di­vorce de­cree’s terms.

The 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 de­cree also should state who is re­spon­si­ble for any fees and how they’re paid.

If a di­vorce de­cree is un­clear on any of these mat­ters, an ad­vi­sor may ask the court for more clar­i­fi­ca­tion. In rare cir­cum­stances, a de­cree may need to be re­vised. Fi­nally, don’t as­sume that your client’s di­vorce at­tor­ney is well versed in how IRAS should be han­dled in a di­vorce.

To get the ball rolling, the ad­vi­sor or IRA owner should pro­vide a copy of the di­vorce de­cree to the IRA cus­to­dian. With­out this, the IRA cus­to­dian has no au­thor­ity to move the IRA funds, so the cus­to­dian will want to see this doc­u­ment be­fore con­duct­ing any trans­ac­tions.

What you can­not do in a di­vorce is take a dis­tri­bu­tion from the IRA and trans­fer those funds to a checking ac­count.

The IRA owner should then com­plete pa­per­work with the IRA cus­to­dian, au­tho­riz­ing a di­rect trans­fer of the IRA or the por­tion of it awarded to the ex-spouse. Be­cause the ac­count be­longs to the IRA owner, the au­tho­riza­tion must come from him to move the funds.

Also, the IRA owner is the one sub­ject to the court or­der. If the ex-spouse al­ready has her own IRA, the funds may be trans­ferred to that ac­count. If the exspouse doesn’t have an IRA, then she’ll need to estab­lish

one to re­ceive the IRA funds awarded un­der the di­vorce de­cree.

The IRA cus­to­dian will then move the funds from the IRA to the exspouse’s IRA. This is ac­com­plished by a trustee-to-trustee trans­fer, in which the funds will move di­rectly from one spouse’s IRA to the other spouse’s IRA. There is no re­port­ing is­sued to the IRS. Forms 1099-R and 5498 are not re­quired be­cause the trans­ac­tion is han­dled as a trans­fer and not as a dis­tri­bu­tion and sub­se­quent rollover.

What not to do: When Dr. Kirk­patrick and his wife were fight­ing bit­terly over cus­tody and visi­ta­tion for their chil­dren, spousal sup­port and the di­vi­sion of as­sets. Near the end of that year, they reached an agree­ment on some of the is­sues. In that con­sent de­cree, Dr. Kirk­patrick was to trans­fer $100,000 from his IRA to an IRA for Chris­tiana Kirk­patrick, and to pay her $40,000 in at­tor­ney fees. The di­vorce was even­tu­ally fi­nal­ized in 2014.

The di­vorce or­der stated that the $100,000 IRA trans­fer to Chris­tiana should be done “di­rectly” and “in a non­tax­able trans­ac­tion” into “an IRA ap­pro­pri­ately ti­tled in Ms. Kirk­patrick’s name.” But that was not done.

Costly Er­ror

In­stead, Dr. Kirk­patrick made two with­drawals from his IRA dur­ing that year. The funds were de­posited into his checking ac­count and he made a se­ries of pay­ments to his ex-wife and third par­ties to sat­isfy the $140,000 or­der. The cou­ple filed a joint re­turn for 2013 and ex­cluded the $140,000 from their tax­able in­come. They be­lieved that the with­drawals were trans­fers due to a di­vorce and were there­fore non­tax­able.

The IRS dis­agreed and is­sued a no­tice of delin­quency. Thus, the ques­tion be­fore the Tax Court was whether Dr. Kirk­patrick com­pleted a tax-free trans­fer of his IRA by tak­ing the dis­tri­bu­tions and di­rectly pay­ing his ex-spouse and some of her cred­i­tors.

The court’s de­ci­sion: The IRS won. The court held that the IRA with­drawals were not tax-free trans­fers due to a di­vorce. In­stead, they were reg­u­lar dis­tri­bu­tions, sub­ject to in­come taxes.

If the ex-spouse doesn’t have an IRA, then she’ll need to estab­lish one to re­ceive the IRA funds awarded un­der a di­vorce de­cree.

Dr. Kirk­patrick be­lieved that the ex­cep­tion ap­plied to any IRA dis­tri­bu­tion that was trans­ferred to an exspouse if it was re­quired by the di­vorce court and com­pleted be­fore the di­vorce was fi­nal­ized. More­over, he ar­gued that even though the funds passed through a checking ac­count, it should have no bear­ing since the money was ul­ti­mately trans­ferred out of the ac­count and to the ex-spouse be­fore the di­vorce was fi­nal. Fi­nally, he ar­gued the num­ber of trans­fers and the method of trans­fer should have no bear­ing on the tax sta­tus of a trans­ferred IRA dis­tri­bu­tion.

The court first dis­missed the ar­gu­ment re­lated to the $40,000 in at­tor­ney fees. Noth­ing in the orig­i­nal con­sent de­cree re­quired the debt to be paid with IRA as­sets. For the ex­cep­tion to ap­ply, the di­vorce court must specif­i­cally or­der a trans­fer of IRA as­sets. These ex­penses could have been paid from any as­set source — re­tire­ment plan or not.

Sec­ond, the Tax Court re­jected Dr. Kirk­patrick’s ar­gu­ment that tak­ing an ac­tual dis­tri­bu­tion had no im­pact on its tax­able sta­tus. The court pointed out that it had pre­vi­ously ruled that the IRA ex­cep­tion doesn’t ap­ply to pro­ceeds from an IRA cashed out and paid or trans­ferred to an ex-spouse after a di­vorce de­cree. In cit­ing the case of Bun­ney v. Com­mis­sioner, the court de­scribed the two com­mon meth­ods of ex­e­cut­ing a tax-free IRA trans­fer due to a di­vorce: 1) reti­tling the IRA to the other spouse or 2) di­rectly trans­fer­ring funds from one spouse’s IRA to another.

From the court: “Here, all rel­e­vant sources – the Code; the caselaw; In­ter­nal Rev­enue Ser­vice guid­ance...; and even the con­sent or­der in pe­ti­tioner’s di­vorce pro­ceed­ings – sug­gest that tak­ing dis­tri­bu­tions from IRAS and writ­ing checks to one’s spouse is not the ap­pro­pri­ate form for a tax-free trans­fer of an ac­count in­ci­dent to di­vorce un­der sec­tion 408(d)(6).”

Dr. Kirk­patrick lost his case. This could have been avoided if he had fol­lowed the judge’s ad­vice in the ear­lier state court or­der.

The Truth Tim­ing and lim­its:

It’s hard to un­der­stand where the Kirk­patricks came up with the funky time frame for qual­i­fy­ing for the ex­cep­tion. The truth is, there is no time frame. As long as the trans­fer is done in line with a di­vorce de­cree and by one of the meth­ods stated above, it will be a tax-free trans­fer. That means it can oc­cur be­fore or after the di­vorce is fi­nal­ized. More­over, there are no lim­its on the num­ber of trans­fers. Again, it just needs to be pur­suant to the di­vorce de­cree or or­der. Thus, a court could or­der two tax-free IRA trans­fers to oc­cur in sep­a­rate years.

While some laws are un­clear, and have gray ar­eas, that is not the case here. The Tax Court has rou­tinely held that tak­ing an IRA dis­tri­bu­tion and then trans­fer­ring those funds to an ex-spouse does not qual­ify as a tax-free trans­fer due to a di­vorce.

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