Jan 01, 2018
By Mike Mesch, CPA/ABV, ASA, CFF, Partner at Terry Lockridge & Dunn
Divorce often involves the splitting of major financial assets, and an IRA plan is, in some cases, a couple’s largest single financial 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
Here are 3 important facts to be aware of:
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.
A casual agreement settling the division of their property, without the involvement of a court, is not enough to divide an IRA. 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.
Additionally, 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.
Also, the divorce decree should clearly state who is responsible for any fees and how they are to be paid.
2. QDROs do not apply to IRAs
A Qualified Domestic Relations Oder (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 retirement funds are divided under a QDRO and paid out from the plan to the alternate payee, there is an exception to the 10% early distribution tax penalty. After a 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 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 due to divorce may also convert those funds to a Roth IRA.
The correct way to divide IRA funds in compliance with a divorce decree is to do 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 done correctly, the IRA will be split and there will be no tax liability for either spouse. Please work closely with your tax accountant and financial advisor whenever going through divorce proceeding to help you stay away from unintended tax consequences.To discuss your specific situation, please reach out to Mike Mesch at firstname.lastname@example.org, or contact any of our professionals at Terry Lockridge & Dunn or World Trend Financial. They can be reached at 319.364.2945 in Cedar Rapids or 319.339.4884 in Iowa City.