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

30-Mar-21

Roth IRAs and Divorce

Take-Away: In something of a surprise, the IRS has never provided any direct advice on the tax consequences resulting from the division of a Roth IRA in a divorce. The best analogy for guidance is when a spouse inherits a deceased spouse’s Roth IRA.

Background: There is a distinct lack of guidance with regard to the tax consequences of when a spouse’s Roth IRA is divided or awarded in a divorce. The Tax Code and  the Regulations are silent. About the only guidance is with respect to the division of a traditional IRA covered in the Tax Code and Regulations and also in IRS Publication 590-A. Yet the tax treatment of traditional IRAs and Roth IRAs are substantially different, along with different rules that need to be navigated. While the IRS Publication is silent with regard to Roth IRAs, the Tax Code specifies that “unless it otherwise expressly indicates the contrary, Roth IRA rules will be treated in the same manner as traditional IRAs.” [IRC 408A(a).]

Divisions: The IRS Publication identifies two common methods to transfer IRA assets to a spouse or a former spouse in a divorce: (i) retitling/changing the name on the IRA; and (ii) making a direct transfer of IRA assets. If either method is followed, the transfer of the IRA assets to a former spouse is tax-free. Not following these transfer rules will result in immediate taxation to the IRA owner. As has been reported in the past, a rollover will not work; the IRA owner cannot take a distribution from the IRA and then deliver the cash to their former spouse to comply with a divorce decree and avoid income taxation. [This failure to follow the IRA transfer rules, or the divorce decree, often happens more than you would imagine, given the high level of emotion that goes with divorce and/or the spite impulse of many controlling ‘husbands.’]

Roth Five-Year Rule: Also a topic that has been covered in the past is the 5-year ‘holding’ rule for Roth IRAs. The Roth IRA owner cannot take a tax-free distribution of earnings from the Roth IRA until 5 years have passed since the Roth IRA was opened, and the owner is age 59 ½ or older. Opening any Roth IRA with even a nominal amount starts this 5-year period to run. For an older individual who opens a Roth IRA later in life, the 5-year rule must still be satisfied, even if that individual is over age 59 ½. This 5-year rule can pose problems if a divorce judge orders the division or transfer of the Roth IRA to the former spouse.

  • Inherited Roth IRA Analogy: The IRS Regulations for Roth IRAs address how this 5-year rule is dealt with when the Roth IRA owner dies and his or her spouse inherits the Roth IRA. The Regulations provide that the 5-year rule is not re-determined when the Roth IRA owner dies. Accordingly, if a surviving spouse inherits the decedent’s Roth IRA and 5 years have not elapsed, the spouse beneficiary may include the period in which the deceased spouse held the Roth IRA. In short, the 5-year period carries over to the surviving spouse beneficiary. [CFR 1.408A-6, Q&A Item 7.]
  • 5-Years Start with Any Roth IRA: If the surviving spouse had his or her own Roth IRA and they inherit their deceased spouse’s Roth IRA, and their own Roth IRA was established longer than the Roth IRA that they just inherited, their ‘older’ Roth IRA controls the 5-year period, not the duration of the just-inherited Roth IRA. Applying these ‘inheritance’ rules to a Roth IRA that is awarded in a divorce settlement, the former spouse’s own Roth IRA could control when the required 5-year holding period starts. Otherwise, the former spouse who is awarded some or all of the Roth IRA owner’s account will still have to fulfill the 5-year holding period before earnings from the Roth IRA can be taken from that awarded Roth IRA income tax-free.

Roth 5-Year Conversion Rule: Also as  has been was previously reported, a Roth IRA has potentially two separate 5-year duration periods to satisfy. The first, as noted, is when the Roth IRA owner initially opened a Roth IRA. The second occurs when a particular Roth conversion was done, a separate conversion 5-year rule. This second 5-year  conversion rule applies to determine if the 10% early withdrawal penalty applies to distributions of converted dollars by someone under age 59 ½. This only applies to conversions of traditional IRAs to Roth IRAs less than 5 years before a proposed distribution.

  • Inherited Roth IRA Analogy: Again, using the analogy of a converted Roth IRA that is inherited by a spouse within 5 years of the Roth IRA conversion, it would seem that the 5-year conversion rule would also carry over to the Roth IRA that is awarded to a former spouse in a divorce.

Example: Will, age 63, and Kate, age 55, get a divorce. Will has no IRA while Kate has maintained a Roth IRA for the past ten years. Kate also converted a traditional IRA to a Roth IRA two years before the divorce. The divorce judge orders Kate to divide her Roth IRAs equally with Will.

  • Will acquires part of Kate’s 5-year Roth IRA, which she started ten years ago. Will does not have to pay income taxes on the distribution of any earnings from Kate’s ‘old’ Roth IRA, as the 5-year holding period is satisfied.
  • Will also acquires 50% of Kate’s converted Roth IRA, which took place two years ago. Since Will is over the age 59 ½ he may withdraw the earnings from the Roth IRA without paying any penalty. Even though Will never had a Roth IRA of his own, the combination of Kate’s 5-year+ holding period for the Roth IRA, combined with Will’s age, allows him full access to the earnings and funds in the awarded Roth IRAs. Kate’s age, 55 years, does not transfer to Will; he is able to use his own age.
  • Note, however, that Kate is still under the age 59 ½. Kate must abide by the 5-year Roth conversion rule applicable to the Roth IRA that she converted two years earlier. If Kate takes a distribution of earnings from her remaining portion of the converted Roth IRA, she will pay the 10% penalty.

Roth Pro-Rata Rule: A Roth IRA may consist of three types of assets: (i) contributions; (ii) earnings; and (iii) conversions. These types of assets will retain their same character after the owner’s death and thus they should continue even after the Roth IRA is divided and transferred in a divorce between spouses.

  • Inherited Roth IRA Analogy: The IRS Publication addresses this pro-rata distribution of non-qualified assets from a Roth IRA to its beneficiaries after the Roth IRA owner’s death: “Each type of Roth IRA asset is divided among multiple beneficiaries according to the pro-rata share of each.” Accordingly, if a divorce court awards part of a Roth IRA to a former spouse, and that Roth IRA contains all three types of assets, the former spouse should receive a pro-rata portion of each type of asset held in the awarded Roth IRA.
  • Identifying the Character of the Roth IRA Assets: Tracking the character of the asset mix in the divided Roth IRA in a divorce might pose a challenge. There are no tax forms that show contributions, conversions, or earnings with a Roth IRA, and the recipient former spouse will not have, ordinarily, any access to this information. As part of the divorce discovery process, the receiving former spouse should obtain copies of all previous Form 5498s, which could go back many years. The information gleaned from the Form 5498’s will enable the receiving former spouse to determine the dollar amount of contributions to the Roth IRA (basis) and also the amount of the converted Roth IRA if it is still within the 5-year conversion window, i.e. when the conversion was done and how much time remains before the receiving spouse will have access to the conversion dollars income tax-free and penalty-free.

Conclusion: It would be nice if the IRS provided Regulations on the tax treatment of a Roth IRA that is awarded or divided in a divorce between spouses. In the absence of any formal guidance, reference to the rules that apply when a spouse inherits a Roth IRA should be followed.