Tax Ramifications of Retirement Plan Transfers in a Divorce

Tax Ramifications of Retirement Plan Transfers in a Divorce – Kurtis P. Kron, CPA

There are a multitude of issues, both emotional and financial, that one encounters when going through a divorce.  Often overlooked in this process are the tax ramifications.  This article addresses the tax aspects of retirement plan transfers pursuant to a divorce.

The divorce process often includes a marital property settlement and this settlement is frequently funded by one spouse’s retirement plan.  The settlement money can come from either a qualified plan (401(k), profit sharing, money purchase pension, etc.) or an IRA (traditional IRA, Roth IRA, SEP, or SIMPLE) and there are subtle differences in the tax treatment of each of these.  There is no tax consequence to the payer spouse as the payer spouse is not taxed on such a transfer of retirement money.  The tax treatment we speak of pertains to the recipient spouse.  The recipient generally will be taxed on the receipt of such money unless rolled over into their own retirement plan.  So let’s look at the details of these situations.

QUALIFIED PLAN – A transfer to the recipient spouse from a qualified plan must be made under a qualified domestic relations order (QDRO) in order to qualify for favorable tax treatment.  (The favorable tax treatment I speak of here is the avoidance of the 10% penalty one must pay for taking retirement plan distributions before they reach age 59 ½.)  In this situation the recipient spouse has the option of rolling over the amount received and not paying tax on that money or simply keeping the money and paying tax on it.  Any rollover must be done within 60 days of receipt of such money.  If this money is moved in a trustee to trustee transfer and it never hits the hands of the recipient spouse, then this 60 day rule is a nonissue.  Should the recipient spouse decide to keep this money and pay tax on it, it will NOT be subject to the 10% premature distribution penalty regardless of whether the recipient spouse is 59 ½ years old or not.

Remember that these tax advantages only exist for qualified plans when this transfer is made pursuant to a QDRO.  The QDRO should specify:

1. The name and address of both the plan participant and the former spouse to receive benefits.
2. The percentage or amount of the benefits to be paid to the former spouse.
3. The period over which the payments are to be made.
4. Each qualified plan to which the order applies.

The QDRO requirements must be carefully followed to ensure the favorable tax treatment for the recipient spouse.

The above discussion regarding transfers from qualified plans pursuant to a QDRO presents an important planning opportunity for a recipient spouse who is not 59 ½ years old.  If that spouse does not rollover the money, that spouse pays income tax and no 10% penalty.  If that spouse does rollover that money and then takes out a distribution from their own retirement account, that spouse pays income tax AND the 10% penalty on the money taken out.  So, when the recipient spouse is faced with this situation, they should carefully consider their cash needs for the near future and only roll over that money which they feel that they can leave alone until they reach 59 ½ years of age.

IRA – Now let’s look at what happens when the transfer to the recipient spouse comes from an IRA instead of a qualified plan.  As long as the transfer is pursuant to a divorce decree or separation agreement and the recipient spouse rolls over the money in a trustee to trustee transfer, then the money is not taxed.  Note that, while a divorce or separation instrument is necessary, a QDRO is not necessary to avoid taxation.  The divorce decree or separation agreement must specifically require the transfer.  It is wise to have the instrument state that the transfer is intended to be tax free under IRC Sec. 408(d)(6).  Also note the trustee to trustee requirement.  If the recipient spouse receives the money and then rolls it over to their IRA, they have not satisfied the trustee to trustee requirement and the money will be taxed.

Another major difference in the treatment of the IRA transfer is the application of the 10% premature distribution penalty.  If the recipient spouse keeps the money instead of rolling it over into an IRA, then the money is not only taxed, it is also subject to the 10% premature distribution penalty.  This provides another planning opportunity.  If the recipient spouse does not plan on rolling over the money, the 10% penalty can be avoided by having that money come from a qualified plan instead of an IRA.

As with any tax situation, it is difficult to generalize the one correct way to do things.  The specifics of each case must be analyzed to determine the most tax efficient way to structure these property transfers.  Be sure to consult with your accountant or attorney prior to finalizing any such transactions.