November 27, 2017

If a couple is getting a divorce, transfers of cash and property between them generally have no immediate federal tax consequences. This general rule allows divorcing individuals to divide up cash, CDs, investments held in taxable accounts, real property, personal property, business ownership interests and other assets without owing anything to Uncle Sam. Such tax-free transfers are allowed before the divorce at the time it becomes final — and afterwards if they’re made as part of the divorce agreement.

Here’s the issue: You may have heard about the tax-free transfer rule, but you may be unaware that it doesn’t apply to transfers of IRA balances. To split up IRAs without unfavorable or unexpected tax results, special handling is required — as illustrated by one U.S. Tax Court case.

Split IRAs the Tax-Smart Way

A divorcing individual can transfer an interest in an IRA to a spouse or ex-spouse in a tax-free transaction if — and only if — the transfer is required by a written divorce or separation instrument. In this situation, the transfer can be accomplished via what amounts to a tax-free rollover of the applicable amount from the individual’s IRA into the ex-spouse’s IRA. Thereafter, the ex-spouse can manage the transferred money as he or she sees fit and continue to defer taxes until withdrawals are taken from the IRA containing the transferred funds. At that point, the ex-spouse will be the one who owes any income tax on the withdrawals. The same rules apply to Roth IRAs, SEP accounts and SIMPLE-IRAs, because they’re all considered IRAs for this purpose.

To be sure things turn out the way you expect if you’re the one transferring an IRA balance to your ex, the divorce or separation instrument should include the following words: “Any division of property accomplished or facilitated by any transfer of IRA funds from one spouse or ex-spouse to the other is deemed made pursuant to this divorce agreement and is intended to be tax free pursuant to Section 408(d)(6) of the Internal Revenue Code of 1986.” This is referred to as a qualified domestic relations order (QDRO).

The way to lock in tax-free results for a transfer of your IRA funds is to arrange for a direct trustee-to-trustee transfer into a new rollover IRA set up by your ex specifically to receive the transferred funds.

Divorce or Separation Instrument Defined

For purposes of making a tax-free transfer of IRA funds to the other party in a divorce, the tax code defines a divorce or separation instrument as a “decree of divorce or separate maintenance or a written instrument incident to such a decree.” However, a separation agreement or a decree requiring a spouse to make temporary payments to support the other spouse (called temporary support orders and temporary alimony orders) doesn’t meet the definition of a divorce or separation instrument.

Therefore, transfers of an account owner’s IRA money to a spouse or ex-spouse pursuant to these other types of divorce-related instruments will be treated as taxable distributions to the account owner, and that person must pay the tax bill even if the money goes to the other party. Don’t let this happen to you!

At-Risk Situations

Probably the most common way that IRA problems arise in divorce situations is when account owners decide to voluntarily give the other party some or all of the money in an IRA. Usually, the account owner is willing to do this because:

  • The other party is hurting financially.
  • There’s no doubt the other party will ultimately receive that amount of IRA money (or more) anyway when the divorce goes through.
  • The account owner believes the money can be rolled over tax-free into the other party’s IRA. This is not true! Don’t transfer any IRA money to the other party, except as duly required by a divorce or separation instrument that meets the definition explained above.

Consequences of Getting It Wrong

When money from an IRA set up in your name gets into the hands of a spouse or ex-spouse’s in an incorrect manner for tax purposes (before or after a divorce), it’s deemed to be a taxable distribution from your IRA to you. That means you’re liable for the related income taxes. To add insult to injury, if you aren’t age 59½ or older, you’ll generally owe the 10% early withdrawal penalty on the distribution.

Court Decision Is a Case in Point

In the facts underlying one Tax Court case, a young couple decided to negotiate the terms of their divorce without hiring an attorney or obtaining professional tax advice. Before the divorce was finalized, the husband liquidated his IRA and gave half of the money to his soon-to-be former spouse. He kept the other half.

The husband knew he owed income tax on the IRA funds given to his wife, but he didn’t think he owed the 10% early withdrawal penalty. He argued that he qualified for an exception because the distribution was made pursuant to a QDRO. Unfortunately for him, the court agreed with the IRS that the husband owed the 10% early withdrawal penalty on the amount that went to his spouse as well as on the amount he kept for himself.

“Although we have great sympathy for (his) position, we are unable to conclude that he satisfied the technical requirements that Congress placed in the statute,” the court stated. (Summers, TC Memo 2017-125)

The Lesson

Divorces can be major financial transactions. As such, they can have major tax consequences. Unfortunately, tax traps for the unwary can be laid for divorcing individuals who split up their IRAs. Be aware that even some divorce attorneys aren’t familiar with the related tax rules. To avoid unpleasant tax surprises, be sure to have a professional with experience in divorce-related tax issues on your side.

© 2017