Take-Away: If the owner of an IRA is later in a divorce, the division of the owner’s IRA needs to take place either after the divorce is completed, or there must be  signed property settlement agreement that contractually directs the IRA’s division and that agreement is later incorporated into the Judgment of Divorce, i.e. making it the judge’s division of the IRA. In order to shift income tax consequences and avoid penalties associated with IRA distributions, timing is everything when an IRA is divided in a divorce.

Background: Many young lawyers get confused when they encounter the division of an IRA in a divorce. They think that a qualified domestic relations order (or QDRO) is  required to implement the division of the IRA between spouses, but that is not the case. A QDRO is used to divide a qualified plan account balance, e.g. a 401(k) account balance or a profit sharing account balance.

  • IRA Division: A QDRO is not used to divide one spouse’s IRA incident to the divorce. Rather, IRC 408(d) permits a division of one spouse’s IRA account, and so long as the original IRA custodian transfers the funds directly to the IRA custodian for an IRA that is opened by the former spouse, no income tax or penalty is imposed on the original IRA owner when the funds are distributed to the new IRA. Thus, to implement a division of one spouse’s IRA in a divorce, the property settlement agreement, and/or judgment of divorce, must: (i) direct the division of one spouse’s IRA; (ii) direct the original IRA owner to tell his/her IRA custodian to transfer an amount or percentage of the existing IRA to the new rollover IRA; and (iii) direct the former spouse to open his/her own new rollover IRA into which a portion, or a specific amount, of the existing IRA is to be paid. The result is a court-ordered custodian-to-custodian transfer of IRA assets. If the former spouse has his/her own IRA, the transfer of funds can be to that preexisting IRA- a new IRA does not have to be created merely to receive the divided IRA.
  • QDRO: There is no need to create a separate QDRO to accomplish a division of an IRA. A QDRO is only used to divide a qualified plan account, or a defined pension benefit.
  • Tax Effect: Following these steps required to divide one spouse’s IRA, the transfer of part of the existing IRA to the former spouse’s new rollover IRA is not currently taxable either to the current IRA owner, or to the former spouse, and the 10% early distribution penalty is avoided.
  • EDRO: [Side-note: If the retirement plan is a plan that is not covered by ERISA, such as a Michigan Public School Retirement Plan System account, then the court order used to divide that public employee’s account balance in the divorce is called an EDRO [Eligible Domestic Relations Order], not a QDRO. The EDRO provisions are much like what are required for a QDRO, but they are not exactly alike, and those small discrepancies can create some traps for the lawyers who do not follow separate EDRO rules.]

Timing Mistakes:  There seem to be a lot of innocent mistakes when IRAs are divided in a divorce. A recent example is a Tax Court Memo decision, Summers v Commissioner, TC Memo 2017-125 (June 26, 2017) where a nice-guy husband made a costly mistake.

  • Facts: and Mrs. Summers decided to divorce. They agree to divide Jeremy’s IRA as part of their divorce settlement. At this point, it was nothing more than a verbal agreement between spouses. Jeremy pulls 100% of his IRA out of his existing IRA and he places the withdrawn assets in a joint checking account with his wife, Karie. The next day Jeremy writes a check for almost 50% of the IRA deposited amount to Karie, to enable her to pay off a car loan that was nearing a default. Jeremy later writes another check to Karie for $71 to make sure that she ultimately received 50% of Jeremy’s IRA account balance, thus fulfilling their verbal agreement to equally divide Jeremy’s IRA. One of the spouse’s then files for divorce.  The divorce swiftly ends, and each of the Summers goes their separate way. Their final judgment of divorce is silent as to any retirement assets, since both spouses  retained the IRA distributed funds or, in Karie’s case, they were used to pay debts. Jeremy later receives a Form 1099-R from Edward Jones as a taxable distribution of his IRA account balance. Jeremy understands that he must pay income tax on the IRA distribution that he received.
  • IRC 72(t): The IRS then gets involved. It imposes a 10% penalty on Jeremy because he was under the age 59 1/2 years. IRC 72(t)(1) imposes this penalty on early distributions from any qualified retirement plan or IRA. See IRC 408(a). Jeremy withdrew the funds from his IRA and deposited those funds into a joint account with his then-wife. Because those IRA assets were not rolled by Jeremy into a new IRA within 60 days of his withdrawal, Jeremy is treated as having received a taxable distribution of the entire IRA balance, and since he was not then over age 59 1/2, the 10% penalty (a non-deductible excise tax) was assessed for Jeremy’s premature withdrawal from his IRA. The Tax Court confirmed this tax treatment to Jeremy.
  • Penalty: The big surprise to Jeremy is that he also got hit with a 10% penalty on the amount that he turned over to Karie. Jeremy, not Karie, owned the IRA when the balance was distributed to him; the fact that the withdrawn amount went into a joint checking account, and the fact that Karie received 50% of the account balance was irrelevant to the Tax Court.
  • Penalty Exception IRC 72(t)(2): The Tax Code contains some limited exceptions from the mandatory imposition of the 10% excise tax for distributions prior to age 59 1/2. One key exception for is for a transfer of funds incident to a divorce, if it is a domestic relations order (QDRO or EDRO) that directs payment of the retirement account to an alternate payee. See IRC72(t)(2)(C). A domestic relations order is defined as a judgment, decree or order that relates to child support, alimony, or marital property rights. IRC 414(p)(1)(B). Accordingly, when a transfer of retirement plan assets is made to a former spouse pursuant to a QDRO (or EDRO), there is no 10% penalty imposed. Similarly, if the divorce judge orders the division of an IRA and there is a direct custodian-to-custodian transfer of the IRA assets, there is no 10% penalty imposed on the IRA transfer, and thus no immediate income taxation of the transferred funds to the former spouse’s rollover IRC 408(d).  But a taxpayer must strictly comply with the requirements of IRC 72(t)(2)(c).
  • Jeremy’s Problem: The IRA distribution was made directly to Jeremy, and he deposited the distribution check into a joint bank account. Jeremy subsequently transferred to Karie an amount equal to 50% of his IRA as he agreed to do. While Karie ultimately received her 50% share of Jeremy’s IRA, the distribution itself was made to Jeremy, not to a ‘former spouse who is recognized by a domestic relations order as having a right to receive’ a share of the proceeds. IRC 414(p)(8). In addition, the distribution to Karie was not made pursuant to a qualified domestic relations order. While Jeremy’s petition for the divorce mentioned this intent to make a 50-50 division of his IRA, he jumped the gun by his well-intentioned decision to divide the IRA with his wife a month before the divorce decree was entered by the court to enable Karie to pay her car loan. Moreover, the divorce decree later recited that “neither party has a retirement, pension, deferred compensation, 401k plan and/or benefits.” Consequently, the IRA distribution was not made pursuant to’ a judicial decree- the IRA’s division was made before  the judicial decree. Thus, Jeremy pays an income tax on 100% of the entire IRA distribution and he also pays a 10% early withdrawal penalty on the entire IRA distribution;  Karie ends up with 50% of the gross amount of the IRA account balance.
  • After-Tax Consequence: Jeremy and Karie agreed to divide Jeremy’s IRA equally, clearly a laudable goal for two people approaching a divorce. When the after-tax consequences are factored in, Karie received $7,500 which she admittedly used to pay down/off a car loan. Jeremy’s share of the same IRA was reduced by federal and state income taxes (roughly $3,000) and the 10% early distribution penalty ($1,500) leaving Jeremy with $3,000 net. Had Jeremy’s IRA been divided pursuant to the divorce decree (entered 30 days later) the 10% penalty could have been completely avoided, and arguably he could have shifted the income tax associated with the $7,500 share of the IRA onto Karrie, who may have been in a ‘no-tax’ bracket at that time [the record is silent if Karie had other income available to her.]

Conclusion:  The Tax Court judge had ‘considerable sympathy for Jeremy and his willingness to help minimize the stress on his son-to-be-ex-wife’ caused by her auto loan being called. But the judge refused to find an equitable exception to  statutory scheme created by Congress to address the division of retirement benefits incident to a divorce. While a formal QDRO is not required to divide an IRA in a divorce, since IRC 408(d) contemplates a divorce judgment’s division of the IRA with a custodian-to-custodian transfer, it is important that a division, whether an IRA or a qualified plan account, be incorporated into a judgment of divorce that satisfies the QDRO [or EDRO] requirements. Maybe nice guys do finish last. By being a nice guy and not waiting for the entry of the divorce decree to divide his IRA, Jeremy found that he did not, in fact, equally divide his IRA with Karie. If Jeremy had consulted with a lawyer or financial advisor, this costly mistake might not have been made.