Getting A Divorce? Understand the Rules Of Dividing Plan Assets

If you are going through a divorce or legal separation and you or your spouse own retirement plan assets, you will most likely be required to share these assets. In some cases, the assets may be awarded to one party. Whether you are giving up the assets or receiving them, you need to understand the rules that govern the asset division. Proper handling is critical in ensuring that the right party is responsible for paying applicable taxes. The type of retirement plan - that is, whether it is an IRA or qualified plan - determines the rules that apply. The following is an overview of these rules.

Qualified Domestic Relations Order versus Divorce Decree
Some courts apply the term "qualified domestic relations" (QDRO) to IRAs, but QDRO applies to qualified plans and 403(b) accounts, not IRAs. For divorce settlements, the term "transfer incident" is applicable to IRAs. To ensure that the proper language is used in the documentation, parties involved in a divorce settlement must be sure to inform the attending judge of their type of retirement plan.

IRAs IRA assets may be divided (or awarded to the spouse of the IRA owner) in accordance with a court-approved divorce decree or legal separation agreement. This division is treated as a non-taxable transaction, which could be a transfer or rollover, depending on the financial institution. The spouse who receives the assets (referred to as "former spouse") is required to treat the assets as his or her own and is responsible for adding any subsequent distributions into his or her income for the year the distribution occurs. Should an individual give IRA assets to a former spouse without receiving a court-approved divorce decree or separation agreement authorizing the change in ownership, the individual will be required to include the amount in income, that is, treat the transaction as a distribution to him/herself. For the divorce decree to be used to allocate the IRA assets, the document must address the retirement assets and stipulate how the division should be allocated, that is, whether the assets are shared equally, awarded entirely to one person, awarded partly to one person, etc. Some financial institutions require that the divorce decree reference the retirement account\'s number and the custodian/trustee. The IRA owner must be sure to check with the financial institution regarding its requirements and provide the information to the court. Qualified Plans and 403(b)s The laws that govern qualified plans provide that the assets held in these plans cannot be assigned, alienated or subject to any type of attachment, garnishment, levy or other legal or equitable process. This means that, besides a few narrowly defined exceptions, creditors have no right to qualified-plan assets. One of these exceptions is QDRO, under which a spouse, former spouse, child or any other person who is a dependent of the plan participant may receive the qualified-plan assets belonging to the participant. The plan administrator is required to review a QDRO to determine if it meets regulatory and plan requirements.

Tax and Penalty Treatment

IRAs The laws provide that IRA assets that are divided in accordance with a court-approved divorce decree or legal separation agreement are treated as a non-taxable transfer. The individual who gives up the assets is not responsible for any tax or penalty of any subsequent distribution that occurs. The former spouse will treat the assets as his or her own IRA and will be responsible for any taxes and penalties resulting from subsequent distributions. Caution must be exercised! There have been numerous instances wherein the spouses have agreed to divide IRA assets in accordance with a separation agreement, but then because the agreement was not approved by the court, the IRS ruled that such a transaction be treated as a distribution to the spouse who gave up the assets. This means that the individual was required to add the amount to his or her income for the year the distribution occurred and was required to pay income tax on the amounts. Of course, the type of IRA will determine the tax treatment. For instance, a qualified distribution from a Roth IRA is tax and penalty free, but an amount distributed in accordance with a separation agreement that was not approved by a court is not eligible to be rolled over or transferred to an IRA of the former spouse. Tracking Basis of IRA Assets The former spouse should check with the IRA owner to determine if the IRA owner made non-deductible contributions to the IRA. Alternatively, the former spouse receiving IRA assets may check past tax returns to obtain this information. If the IRA includes nondeductible assets, both parties will need to inform the IRS of the change in ownership of deductible assets by filing IRS Form 8606. Filing of Form 8606 is important in helping to prevent the former spouse from paying taxes on distributed assets that should be tax free. The parties should consult a tax professional for assistance with filing Form 8606. Qualified Plans The tax treatment of assets received by an alternate payee is determined by the relationship of the alternate payee to the participant. If the alternate payee is the spouse or former spouse, he or she will be responsible for treating the amount as income and paying any applicable income tax. If the alternate payee is a child or other dependent of the participant, the participant is responsible for treating the amount as income and paying any applicable tax. Amounts distributed in accordance with a QDRO is exempted from the 10% early-distribution penalty. A former spouse who receives qualified-plan or 403(b) assets as a result of a QDRO may roll these assets into his or her IRA or other eligible retirement plan. The amount will continue to earn tax-deferred earnings and will not be taxed until he or she receives a distribution from the retirement plan.

Conclusion - Reminder to Update Your Beneficiary Designation
Even when the division of assets after your divorce is settled, you aren't quite finished attending to relevant issues. There are numerous cases of spouses, former spouses and heirs engaging the services of attorneys and the courts to determine the beneficiaries of the retirement-plan assets of a deceased retirement account owner. This occurs when the deceased failed to update his/her beneficiary designation after a divorce or remarriage. Individuals who are recently divorced can save their beneficiaries the stress and legal fight by properly updating their beneficiary designations.