If you are going through a divorce or legal separation and you or your spouse have money in retirement plans, 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 funds or receiving them, you need to understand the rules that govern asset division in a divorce. 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.
Qualified Domestic Relations Order vs. Transfer Incident to Divorce
Even if you and your spouse will divide the assets in your IRAs and qualified plans in exactly the same manner, a separate legal term applies to each type of division. IRAs are divided using a process known as "transfer incident to divorce," while 403(b) and qualified plans, such as a 401(k), are split under the "Qualified Domestic Relations Order" (QDRO).
Many courts confuse this distinction by labeling both types of divisions as QDROs. Nevertheless, you and your spouse need to delineate clearly the category into which each of your retirement assets falls when you submit your information to the judge or mediator so they are listed correctly in the divorce or separation agreement. Not doing this can produce substantial additional – and unnecessary – headaches.
Dividing an IRA: Transfer Incident
If you specified that your IRA division is to be treated as a transfer incident to divorce in your agreement, no tax will be assessed on the separation transaction. The movement of funds may be classified as either a transfer or a rollover by the IRA custodian, depending on the circumstances of the division and how the decree is worded.
The recipient will take legal ownership of the assets when the transfer is complete and then assume sole total responsibility for the tax consequences of any future transactions or distributions. This means that if you are going to give half of your IRA to your soon-to-be-ex-wife in the form of a properly labeled transfer incident, she will have to pay the tax on any distributions she takes out of the account after she receives the funds. You will not owe tax on the assets that were sent to her because you followed the IRS rules for transfer incidents.
If, however, you failed to adequately label your division as such, you will owe both tax and an early withdrawal penalty, if applicable, on the entire amount that your ex-spouse received. In order to avoid this, be sure to clearly list both the division percentage breakdown and the dollar amount of IRA assets being transferred, as well as all the sending and receiving account numbers for all of the IRAs involved in the transfer.
The instructions that you provide need to satisfy both the sending and receiving IRA custodians, as well as the judge and state laws. If the division agreement is not approved by the courts, the IRS will require you to file an amended tax return that reports the entire amount you sent to your ex as ordinary income. Furthermore, the balance your ex received cannot be placed in an IRA because it was not an eligible transfer; this means he or she will lose the benefit of tax deferral on that money – and may come back to you to be compensated for that loss.
Tracking Basis of IRA Assets
Some qualified transfer incidents are made from an IRA that has been partially funded with nondeductible contributions. If this is the case with you, then both you and your ex will need to know the dollar amount of nondeductible contributions and file tax Form 8606 with the IRS in order to correctly calculate and report the apportionment of the nondeductible amounts. Do not hesitate to seek professional help in getting this form filed for both of you; trying to determine the correct amount can be tricky. Neither of you wants to pay unnecessary taxes on IRA distributions that came from contributions that were never deducted.
Dividing a Qualified Plan: QDRO
Divorce constitutes one of the few exceptions to the protections from seizure or attachment by creditors or lawsuits that federal law accords to qualified retirement plans. Divorce and separation decrees allow the attachment of qualified-plan assets by the ex-spouse of the plan owner if the spouse uses a Qualified Domestic Relations Order. This decree is used to divide qualified-retirement–plan assets between the owner and his or her current or ex-spouse or child or other dependent.
QDROs resemble transfers incident to divorce in that they are tax-free transactions as long as they have been reported correctly to the courts and the IRA custodians. The receiving spouse may roll QDRO assets into his or her own qualified plan or into a traditional or Roth IRA (in which case the transfer will be taxed as a conversion but not penalized). Any transfer from a qualified plan pursuant to a divorce settlement that is not deemed a QDRO by the IRS is subject to tax and penalty.
After you send or receive your IRA or qualified-plan assets, be sure to add or update your beneficiaries. Your ex-spouse will probably not be one of them unless your divorce decree requires it. (Also be sure to update the beneficiaries on all your other financial assets, including annuities and life insurance.) If you are going to get remarried and/or your children are now going to be your primary beneficiaries, it may be prudent to create a revocable living trust and make the trust the primary or secondary beneficiary of your plan or account. An estate-planning attorney can help you accomplish this and ensure that your retirement assets will be dispersed in the manner that you desire.
The Bottom Line
Dividing retirement assets in a divorce can be a simple process if you do your homework and report all the correct information to all parties involved. If the courts and the IRA and/or qualified-plan custodians recognize your divisions as QDROs or transfers incident to divorce, there will be no tax consequences for you or your ex. Lack of attention to detail in this matter can make the divorce process that much more complicated and expensive, especially if large sums of money are involved. For more information on how to divide your retirement-plan assets correctly, consult your divorce attorney or financial counselor.