Although it may not seem like it initially, a divorce is a major financial transaction. As such, it has serious tax implications and potential tax pitfalls. This is especially true when it comes to splitting up tax-favored retirement accounts between divorcing spouses. Planning ahead is critical to getting good tax results.
Use a "QDRO" to Divide a Qualified Plan Account
Let's say you have a substantial qualified retirement plan account, such as a Keogh account, company pension account or 401(k) plan. In a divorce, the account will probably be divided between you and your soon-to-be-ex spouse as part of the property settlement. However, making the split in the wrong way can create a real tax problem.
To divide qualified retirement plan accounts the tax-wise way, make sure to use a qualified domestic relations order (QDRO). This simply involves some language that should be included in the divorce papers. First and foremost, the QDRO establishes your ex-spouse's legal right to receive a designated percentage of your retirement account balance or certain retirement benefit payments. The good news: The QDRO also ensures that your ex-spouse, and not you, will be responsible for the related income taxes when he or she takes retirement account withdrawals.
The QDRO arrangement also permits your ex-spouse to withdraw the designated share of the retirement account money and roll it over into his or her own IRA (assuming such a withdrawal is permitted by the terms of the qualified retirement plan in question). By a rollover, your ex-spouse can take over management of the designated share of the retirement account money while postponing income taxes until he or she begins taking withdrawals from the IRA.
The bottom line: A QDRO is a fair deal for both ex-spouses.
So what happens without a QDRO? If money from your qualified retirement plan account gets into your ex-spouse's hands without a QDRO in place, you face a disastrous tax outcome. Specifically, you're treated as if you received a taxable distribution from the retirement account and then turned over the resulting cash to your ex-spouse. So you owe the taxes while your ex-spouse gets the money without owing any taxes. To add insult to injury, you could also get hit with the 10% early withdrawal penalty tax if the distribution occurs when you are younger than age 59 and 1/2.
As you can see, it's critically important to get proper QDRO language into your divorce papers before signing off on the property settlement.
How To Make a Tax-Smart Split of an IRA
Fortunately, you don't need a QDRO to divide an IRA for best tax results. Tax law allows you to arrange for a tax-free rollover of money from your IRA into an IRA set up in your ex-spouse's name. After the rollover, your ex-spouse can then manage the IRA and defer taxes until he or she begins taking money out of the account. As with a QDRO, this procedure also ensures that your ex-spouse, and not you, will owe the resulting income taxes. These rules apply to traditional IRAs, Roth IRAs, SEP accounts and SIMPLE IRAs.
But be careful here. The desired tax-free treatment only applies when the rollover is required by your divorce agreement. What happens if money from your IRA gets into your soon-to-be-ex-spouse's hands before the divorce or into your ex-spouse's hands after the divorce without such a requirement? You are liable for any taxes. Plus you will generally owe the 10% penalty tax if you are under age 59 and 1/2. To avoid these dire tax consequences, you should never try to make a pre-divorce rollover from an IRA into a spouse's IRA. Any such attempt will be treated as a taxable distribution to you as the IRA owner.
Important: When assets are divided in a divorce, there are usually tax issues to consider. This is especially true with tax-favored retirement accounts. Contact your tax advisor for more information.
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