Consider Taxes When Dividing Up Retirement Accounts in Divorce
Getting divorced is a major financial transaction that can have negative tax consequences, particularly when it comes to splitting up tax-favored retirement accounts. Here's how to plan for the optimal tax results for your situation.
Tax-Smart IRA Rollovers
Federal income tax rules allow divorcing spouses to divvy up IRAs without dire tax consequences. You simply arrange for a tax-free rollover of money from your IRA into an IRA set up in your ex's name. Then your ex can manage the rollover IRA and defer taxes until he or she begins taking money out of the account. This ensures that your ex, not you, will owe the resulting income taxes.
The rules apply equally to traditional IRAs, Roth IRAs, SEP accounts and SIMPLE IRAs. They're all considered IRAs for this purpose.
Though the rules seem simple, you need to be careful. The tax-free rollover deal applies only when your divorce agreement requires the rollover.
If money from your IRA gets into your ex's hands before or after the divorce without such a requirement, you'll be treated as if you received the money. That means you'll be on the hook for the related taxes — even though you didn't actually keep the money. Plus, you'll usually owe a 10% penalty tax if you're under age 59½. To avoid this pitfall, you should never transfer IRA money to your ex in advance of a legal requirement in your divorce papers to do so.
Qualified Retirement Plans
To divvy up funds in a qualified retirement plan between divorcing spouses — without incurring an unwelcome tax hit — you'll need to establish a qualified domestic relations order (QDRO). This boilerplate language in your divorce agreement may specify how to split up:
- Qualified retirement plans at work, such as 401(k) plans,
- Self-employed or small business qualified plans, such as Keogh or corporate profit-sharing plans, and
- Defined benefit pension plans.
A QDRO establishes your ex's legal right to receive a designated percentage of your retirement account balance or designated benefit payments from your plan. The good news for you is that the QDRO also ensures that your ex, and not you, will be responsible for the related income taxes when he or she receives payouts from the plan.
The QDRO arrangement also permits your ex-spouse to withdraw his or her share of the retirement plan money and roll it over tax-free into an IRA (assuming the plan permits such a withdrawal). That way, your ex can take over management of the money while postponing income taxes until withdrawals are taken from the rollover IRA.
A QDRO is fair for both spouses. It ensures that the person who gets retirement plan payouts will owe the related income taxes.
However, beware, if money from your qualified retirement plan gets into your ex-spouse's hands without a QDRO being in place, you face a potentially negative tax outcome: You'll be treated as if you received a taxable payout from the plan and then voluntarily turned the money over to your ex. So, you'll owe all the taxes while your ex gets the money tax-free.
To make matters worse, the extra income from a large taxable transfer of retirement account funds could possibly push you into the maximum 37% federal income tax bracket, cause some or all of your investment income to be hit with the dreaded 3.8% net investment income tax (NIIT), and cause you to lose tax breaks due to income-based phase-out rules.
To add further insult to injury, you might also get stung with the 10% early distribution penalty tax if this happens before you've reached age 59½. So, make sure your divorce papers include the necessary QDRO language.
Real-Life Example of Post-Divorce IRA Rollover
The U.S. Tax Court recently ruled that an IRA distribution made after a couple divorced was taxable to the former husband. He also had to pay a 10% early distribution penalty tax. (William E. Rosenberg, T.C. Memo 2019-124.)
The Rosenbergs' divorce was finalized in 2014. The divorce property settlement stated that the former wife had to pay her ex-husband $10,000 from her retirement account. In 2015, she paid the $10,000 by arranging to transfer funds from her IRA to a new IRA that her ex-husband had opened for this purpose.
Within seven days of the transfer, the ex-husband withdrew the funds and closed the IRA. He didn't report the withdrawal as gross income on this 2015 federal income tax return.
The IRS determined that the distribution was taxable to the former husband. The distribution was also subject to the 10% early distribution penalty tax, because he wasn't age 59½ and no exception to the early withdrawal penalty tax applied.
The ex-husband argued that the IRA distribution wasn't taxable income for him, because the existence of the IRA should be disregarded. He argued that the IRA was only an interim step in what was intended to be a simple cash payment from his former wife to him, in accordance with the divorce property settlement. He claimed that his former wife interposed the IRA over his objection, and that he didn't think the transfer of the money into the “temporary” IRA would convert his property settlement into a taxable IRA distribution.
The Tax Court agreed with the IRS that the IRA distribution was taxable to the former husband and subject to the 10% penalty tax. The court held that his stated understanding that his ex would withdraw the funds from her retirement account and transfer them directly to him didn't overcome the fact that the funds were transferred into his IRA and then distributed to him. The court refused to apply common law doctrines to fashion an equitable exception to the statutory tax outcome that applied in this case.
The former wife in this case was tax smart. She arranged for an IRA rollover that effectively transferred the tax burden on the money transferred from her IRA to her ex-husband. If you're in a similar situation, talk to your tax advisor before making any moves.
For More Information
Emotional issues aside, settling the financial aspects of a divorce can be complicated, especially if the parties have been married for many years and have accumulated substantial net worth. Your financial advisors can help you devise various settlement options — including asset allocations and support payments — that minimize potential taxes and meet other personal objectives.