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George F. Bearup, J.D. Senior Legal Trust Advisor

30-Apr-18

IRAs Transferred in a Divorce: Mistakes and Mishandling

Take-Away: All too often individuals make mistakes when they divide their IRA accounts in a divorce. The some problems arise from confusing IRA and qualified retirement plan rules; another problem can be caused by jumping the gun.

Background: These days a major asset accumulated during a marriage is an IRA. How that IRA gets divided as part of the marital estate is usually subject to the negotiation of the spouses. But mistakes are regularly made when dividing and transferring that divided IRA. Some common misunderstandings and mistakes made dividing an IRA incident to a divorce follow:

  • Early Division and Distributions: There can be no transfers of the IRA account before the entry of a divorce judgment or comparable divorce court order addressing the IRA and its division. Reaching a settlement agreement, and then dividing the IRA, but doing so before the divorce settlement agreement is incorporated into a final divorce decree, will cause the IRA owner to be treated as having received a taxable distribution from his/her IRA, and perhaps a 10% early withdrawal penalty as well if the owner is under age 59 ½. Thus,  the timing of the IRA’s division and transfer is critical, which must be tied to the divorce decree or judgment that has been entered, not just the settlement agreement (even when everyone knows the divorce judge will ‘rubber stamp’ that settlement agreement as part of the final divorce judgment.)
  • No QDRO Needed: It was surprising to me when I practiced law how many lawyers thought that they needed a qualified domestic relations order (QDRO) to divide an IRA. A QDRO is necessary to divide the balance of a qualified retirement plan account, e.g. 401(k) or profit sharing account, since those plans are subject to ERISA’s spendthrift and mandatory spousal retirement annuity rules. But QDRO’s are not required to divide an IRA. [IRC 408(d)(6).] A traditional IRA, a SEP IRA and a SIMPLE IRA can all be divided without the need for a QDRO- just a provision in the settlement agreement or judgment of divorce that directs the transfer of funds or a percentage of the IRA to the non-owner spouse’s own IRA.
  • Date of Division and Earnings: If there is an agreement to divide an IRA incident to a divorce, the settlement agreement also needs to address the date of that division and the earnings on the divided account balance,  especially if the IRA is not divided 50%-50% and instead refers to a specific dollar amount. Sometimes, too, the divorce settlement provision can identify investments or mutual funds held in the IRA that are the subject of the transfer to the former spouse’s IRA.  Lots of divorce settlements have found themselves back in court over disputes as to how the earnings are allocated between the time of the IRA division’s agreement and the time of the division after the entry of the divorce judgement, especially when there are long delays between the agreement and getting the judgment of divorce entered or there are wild market swings between the two dates.
  • Cost of the IRA Division: Often divorce settlement agreements are silent on the question of who pays the fees if any are incurred to divide an IRA and transfer the funds, or the fees that are incurred to create a ‘new’ IRA into which part of the ‘old’ IRA is transferred. Fortunately these custodian and transfer fees are minimal, but for folks at the end of a long, protracted and rancorous divorce, a disagreement over even the smallest expense can cause a continuation of the “War of the Roses.”
  • No Tax Reporting: A common mistake is for the settlement agreement to require the IRA owner to produce a Form 1099-R or a Form 5498. These forms are not required with the division of an IRA. What the settlement agreement and court order require is only a transfer of part of the owner’s IRA, not a distribution from the owner’s IRA.
  • No Taxes- But Maybe a Penalty: There is no income tax consequence to either the IRA owner or the former spouse who has part of the owner’s IRA transferred directly to a ‘new’ IRA in the former spouse’s name. But the mistake is then using some of the transferred IRA money to pay bills, e.g. the divorce attorney’s fees incurred, etc. If the IRA funds are withdrawn then there is a distribution which triggers both ordinary income taxes and an early withdrawal penalty of 10% if the owner or former spouse is under age 59 ½. The presence of the 10% penalty when taking a distribution from a post-divorce IRA is different from when a qualified plan account is divided pursuant to an QDRO and a distribution is taken by the former spouse (alternate payee) from his/her share of the divided qualified plan account. [IRC 414(p)(1); 72(t)(2)(C).] Making these rules equally confusing is that when an IRC 403(b) account is divided incident to a divorce, the former spouse can access his/her share of the divided 403(b) account without incurring the 10% penalty, yet that penalty applies when an IRA is divided incident to a divorce and funds are subsequently withdrawn.
  • Elder Divorce and RMDs: More frequently couples in their 70’s get  divorced. They need to take into consideration their required minimum distributions (RMDs) for the year when dividing an IRA. If an IRA owner is taking RMDs there is no provision for adjusting the IRA balance used for his/her RMD calculation in the year the IRA is divided incident to a divorce. The owner still needs to take his/her RMD calculated using the prior December 31 IRA value. This may result in a much larger RMD than anticipated on a much smaller IRA (after its division in the divorce action.) The implications of RMD’s by the IRA owner is frequently forgotten when dividing one spouse’s IRA.

Following the Court Order: Probably the biggest mistake in dividing IRAs incident to the divorce is not delaying the division until after a court order, or following the judgment of divorce that incorporates the property settlement agreement negotiated by the spouses, i.e. following the express terms of the court order or judgment. This common mistake was again on full display in a recent Tax Court case. The facts were pretty straightforward. Dr. Kirkpatrick and his wife, Christina, were in the middle of a nasty divorce. In 2012 they reached an agreement on some issues, but not all. Based on their partial agreement the divorce court entered an order that specifically provided:  “ORDERED, that the Defendant shall transfer to Ms. Kirkpatrick the sum of $100,000 directly (and in a non-taxable transaction) into an IRA appropriately titled in Ms. Kirkpatrick’s name within 14 days of this Order.”

Clearly the court order anticipated a custodian-to-custodian transfer of part of Dr. Kirkpatrick’s IRA account to a new IRA opened by Mrs. Kirkpatrick. But Dr. Kirkpatrick instead took a $100,000 distribution directly from his IRA, the check made payable to him. Dr. Kirkpatrick then he gave the $100,000 to Ms. Kirkpatrick. Dr. Kirkpatrick did not report the $100,000 as an IRA distribution taxable to him. No surprise Dr. Kirkpatrick got audited, and subsequently found himself in Tax Court arguing that the distribution that he received from his IRA was tax-free due to the divorce court order. The Tax Court disagreed with Dr. Kirkpatrick. The Court found  that since Dr. Kirkpatrick did not follow the specific instructions contained in the court order, i.e. he did not transfer the IRA funds to an IRA established by Ms. Kirkpatrick, he instead took a taxable distribution from his IRA:

“Here, all relevant sources- the Code; the case law; Internal Revenue Service guidance…and even the consent order in petitioner’s divorce proceedings- suggest that taking distributions from IRAs and writing checks to one’s spouse is not the appropriate form for a tax-free transfer of an account incident to divorce under section 408(d)(6).”

Note that Dr. Kirkpatrick ended up paying his wife $100,000 and also he incurred an income tax liability on that $100,000 distribution, leaving him even more out-of-pocket. Note, too, the Ms. Kirkpatrick was not able to deposit the $100,000 in an IRA, so that she lost the opportunity to defer income taxes on the growth of that $100,000 (which may have been either a good thing or a bad thing based upon what else she ultimately received in the divorce and her own level of earnings.) John R. Kirkpatrick v. Commissioner, TC Memo 2018-20 (February 22, 2018.)

Beneficiary Designations:  One final caution is that even after the IRA is divided incident to the divorce, it is important to change the IRA owner’s beneficiary designations regarding what is left in his/her IRA account. Most beneficiary designations will have to be changed after the divorce. Michigan’s statute automatically removes a former spouse from an existing IRA beneficiary designation after the divorce which helps to assure that the former spouse will not inherit the deceased spouse’s IRA if the decedent forgets to change the IRA beneficiary after the divorce. [MCL 700.2801.] But that statute does not add new IRA beneficiaries to replace the former spouse as IRA beneficiary, which may result in the IRA custodian’s default beneficiaries taking the balance of the decedent’s IRA. Hence the need to annually revisit the IRA beneficiary designations to confirm that they still are consistent with the owner’s testamentary wishes.