Practically every divorce case involves marital assets to be divided between the parties. Of significant concerns are the tax issues involved in these transfers. Under U.S. Code § 1041 – transfers of property between spouses or incident to divorce, are non-taxable events. In order to utilize a “divorce or separation instrument” to divide an IRA, you should be sure that the judgment or settlement agreement includes language that is sufficient to divide the IRA, provides a clear method of division, provides a valuation date as of which the IRA is to be divided, and addressed gains and losses on the non-owner spouse’s share. Qualified Domestic Relations Orders (QDROs) apply to company retirement plans such as a 401(k). IRAs are not governed by ERISA, and are exempt from ERISA’s QDRO provisions. They do not apply to IRAs. The mistakes that attorneys often make is in cases were that the marital settlement agreements and the final judgement incorrectly references the QDRO rules, NOT the IRA rules. As a result, it is likely that the IRA funds will not properly split in the divorce because the letter of the tax law was not followed. Accordingly, the distribution from the IRA owner’s account would be taxable to the IRA owner and the deposit of those funds into the ex-spouse’s IRA would be treated as an excess IRA contribution. IRAs are Individual Retirement Accounts which are governed by Internal Revenue Code §408. Usually the account owner is the person in control of the IRA, and the account owner is considered the “plan administrator.” The most common type of IRA is the traditional IRA; however, there are also simplified employee pension (SEP) IRAs, savings incentive match plan for employees (SIMPLE) IRAs, education IRAs, and Roth IRAs. Contributions made to an IRA during marriage (from the date of marriage through the date of separation) are considered marital property in Florida and are subject to division due to dissolution of marriage. Section 408(d)(6) of the Internal Revenue Code says that the transfer of an individual’s interest in an IRA account to a spouse or former spouse is not a ‘taxable transfer.’ Essentially, the spouse who gives up the assets is not responsible for any tax or penalty of future distributions that occur. But the spouse who receives the assets — when it becomes their own IRA — will be responsible for any taxes and penalties from future distributions. In order to qualify for a tax free transfer, the IRA transfer to the other spouse must made be pursuant to a divorce agreement or by court order, not a QDRO. A copy of the divorce decree or separation agreement is given to the IRA custodian and the funds are split in three ways: A) Change the owner’s name on the IRA if the entire IRA is to be transferred to the other spouse; B) Trustee-to-Trustee: The IRA owner may direct the IRA trustee to transfer the IRA assets, either in whole or in part, to the trustee of the new existing IRA set up in the name of the recipient spouse; and C) Rollover: Transfer a fixed dollar amount or percentage of the owner’s IRA to a new or existing IRA set up in the name of the recipient spouse. Take a distribution and give the IRA distribution to the recipient spouse who must contribute these IRA assets to a new or existing IRA set up in the recipient spouse’s name. Withdraw the IRA assets, roll those into another IRA in the IRA name and then change the name of the new IRA account to the recipient spouse’s name.
NOTE: If funds are cashed out/distributed and then paid to the spouse/ex-spouse, this is considered a ‘taxable event’ to the owner of the original IRA. It is important that the movement of funds is done as a ‘transfer’ and not a ‘distribution’.
In addition to a judgment or filed settlement agreement, some financial institutions will require a “Letter of Instruction,” signed by the IRA owner, directing them to divide the account. Although IRAs are not governed by ERISA, and are exempt from ERISA’s QDRO provisions, it is usually best to simply provide the financial institution with whatever documentation they require in order to divide the account, whether it is a judgment, settlement agreement, letter of instruction or a separate court order similar to a QDRO. Failure to utilize the correct methods of transfer can result in a mandatory 20% IRS tax withholding. If money is first distributed to an individual and is then rolled over within 60 days of distribution to an IRA or other plan, tax-deferred treatment is possible, but will only apply to 80% of the distribution unless the individual can contribute funds to make up for the 20% that was withheld. Funds received directly by an individual who is not yet 59 ½ will be subject to a 10% early withdrawal penalty. Unlike distributions made to a former spouse from a qualified retirement plan under a Qualified Domestic Relations Order, there is no “divorce” exception to the 10% additional tax on early distributions from IRAs because IRAs are not “qualified retirement plans.”