10-Jan-22
Taxes, Penalties and Divorce: IRAs and Qualified Plans are not the Same
Take-Away: The division of and IRA and a 401(k) account are different in a divorce property settlement, as can be the income tax consequences that result from that division. Differentiating an IRA from a 401(k) account is important to avoid accelerating the income tax liability associated with those retirement accounts. Key to this differentiation is that an IRA is not governed by ERISA.
Background: The Employee Retirement Income Security Act of 1974 (ERISA) controls the accumulation, distribution and division of qualified plan accounts. An individual retirement account (IRA) is not a qualified plan, and as such, it is not controlled by ERISA’s rules including ERISA’s broad spendthrift prohibition.
Qualified Plan Accounts and QDROs: To divide a qualified plan retirement account incident to a divorce requires the use of a qualified domestic relations order, or QDRO. Dividing a qualified plan account without the use of a QDRO will cause an income tax problem for the qualified plan account owner. In addition, distributing plan assets incident to divorce without a QDRO can jeopardize the tax qualified status of the entire ERISA plan, and such a disqualification could cause the immediate income taxation for every participant in the retirement plan, not just the participant who is going through a divorce.
Alternate Payee: The former spouse who shares in the participant spouse’s qualified plan account as part of the divorce settlement is called an alternate payee under the QDRO. If the former spouse, aka alternate payee, takes the funds out of the qualified plan as a distribution, the alternate payee will pay income taxes on that distribution at ordinary income tax rates, since the funds have never been subject to income taxes before. If the funds are not immediately withdrawn by the alternate payee, he/she will become a new beneficiary under the participant’s qualified plan.
No 10% Penalty: One key feature of a QDRO often overlooked by divorce attorneys is that if the former spouse takes a distribution from the qualified plan as authorized under the QDRO as an alternate payee, and the former spouse is under the age 59 ½ at the time of the withdrawal, there will be no 10% penalty imposed on that ‘early’ distribution. While there will be ordinary income taxation of the distribution, there will not be a 10% penalty. In contrast, if the plan participant himself or herself under the age 59 ½ took a distribution from their qualified plan account, the participant would have to pay the 10% penalty for an early distribution.
Common Practice- Rollovers: An alternate payee usually has two options once the qualified plan account is divided pursuant to a QDRO. Most alternate payees roll over their share of the divided qualified plan account into a traditional IRA. That rollover occurs because they do not want to be a participant in their former spouse’s retirement plan; usually they do not want anything to do with their former spouse, or their former spouse’s employer. Instead, they move their share of the divided qualified plan account into an IRA which gives the alternate payee more control over investments, sometimes with lower custodian and investment fees, and with more flexibility in making beneficiary designations over their share of the retirement funds.
‘Wait-and-See’ Rolling Over: While there are obvious advantages to the alternate payee moving their share of the divided retirement funds from the qualified plan to an IRA, there may be a couple of reasons to keep the alternate payee’s share of the retirement funds in the plan sponsor’s qualified plan. ERISA, which governs qualified plans but not IRAs, affords the alternate payee better creditor protection than an IRA, with its strong spendthrift protections. The creditor protection for an IRA is controlled by state law, and each state’s IRA creditor protection is different from the others. If there is a concern about future bankruptcy for the alternate payee, it is important to remember that the federal Bankruptcy Code exempts an unlimited amount held in the bankrupt’s qualified plan account, in contrast to its dollar limit (albeit generous but still limited) held in a traditional IRA. Finally, as noted above, a distribution from a qualified plan incident to a QDRO is exempt from the 10% penalty; the alternate payee may need to access the divided retirement account funds to pay bills and for normal living expenses, which is often the case when wealth is divided in half and there are substantial divorce attorneys’ fees to be paid.
Example: Wendy and Herb get a divorce. Herb has $2.0 million in his 401(k) account. The divorce judgment divides Herb’s 401(k) account 50%-50% between Wendy and Herb. That division of the 401(k) account is implemented with a QDRO. Wendy wants to get as far away from Herb as she possibly can and take her 1.0 million share and move it into a rollover IRA. However, Wendy also knows that she does not have access to Herb’s higher income in her post-divorce life, as she worked part-time during the marriage, and she also has a large attorney’s bill resulting from the divorce that she needs to pay. Wendy is age 55. An IRA rollover is not an ‘all-or-nothing’ proposition for Wendy. Wendy can take $100,000 of her share of Herb’s 401(k) account and roll those funds into an IRA. The balance of her share of Herb’s 401(k) account, $900,000, can stay in the qualified plan in a separate account in Wendy’s name alone. Wendy will then take some of the $100,000 from her traditional IRA and use those funds to pay her attorney fees, and use the balance to support her lifestyle as she re-enters the workforce as a full-time employee with her own earnings to replace Herb’s earnings. Once Wendy attains the age 59 ½, she can then roll the balance of the divided 401(k) account into her IRA, and if she later needs access to those funds, she can take a distribution from her IRA without incurring the 10% penalty. Wendy will pay a 10% penalty, i.e. $10,000, on the $100,000 that she initially rolled over into her IRA to be used to pay her attorneys’ fees.
Individual Retirement Accounts: An IRA is controlled by the Internal Revenue Code, not ERISA. [IRC 408.] An IRA does not require a QDRO to be divided in a divorce action. [IRC 408(d).] The only time that an IRA can be divided tax-free is either on the IRA owner’s death, or when the IRA owner is in a divorce. In order for the IRA owner to not be taxed on the division of his/her IRA in a divorce, a couple of critical rules must be followed.
#1. Written Instrument Incident to the Divorce: To divide the IRA it must be pursuant to a divorce decree or a “written instrument incident to such a decree.” Unfortunately, the Tax Code does not define what is an “instrument incident to a divorce decree.” To avoid any complications, it is imperative that the divorce decree specifically mentions the written instrument, and even better to attach and incorporate by reference the written instrument into the divorce judgment. This rule is sometimes violated in a haste to end the divorce.
Example: Harvey’s IRA is to be divided with Wilma incident to their divorce. Harvey and Wilma have negotiated a settlement, but have not yet signed a settlement agreement where Harvey’s $1.0 million IRA is to be divided equally with Wilma. Harvey goes to his IRA custodian and directs the custodian to transfer the $500,000 from his IRA to Wilma’s IRA that she had previously opened. There is no written instrument when this transfer occurs, nor is the divorce yet final. Harvey took the money from his IRA too early. As a result, Harvey will pay income taxes on $500,000, and if Harvey is under age 59 ½ at the time of the transfer, Harvey will also pay a $50,000 penalty tax.
Custodian-to-Custodian Transfer: While this rule seems fairly straightforward, it is surprising the number of times it is violated. The IRA owner cannot withdraw their former spouse’s share of the IRA and place the withdrawn funds into a checking account, and then turn around and write a check for the same amount to their former spouse. The former spouse’s share of the divided IRA must be transferred from the owner-spouse’s IRA custodian directly to the new IRA custodian for the former spouse. In the past year a Tax Court case was reported where the husband withdrew his former wife’s share of his IRA, and he subsequently wrote her a check for her part, and he used the balance to pay a debt that she had agreed to pay as part of the divorce settlement. Not only did the husband have to pay ordinary income taxes on that entire distribution, he also had to pay a 10% penalty for an early distribution from his IRA.
Prenuptial Agreements: Often a prenuptial agreement will contain a provision that provides that a fiancee’s qualified plan account, or his or her IRA, will remain theirs in the event of divorce or death. ERISA requires the spouse of the qualified plan account participant to provide written consent if someone other than the spouse is to be named as the participant’s beneficiary. While this provision may be included in the prenuptial agreement, arguably it is not binding, for the simple reason that when the agreement was signed, the individuals were not yet married- there was no spouse at that point in time. ERISA is clear that a spouse must sign the joint and survivor annuity right created by the 1984 Retirement Equity Act. As a result, the waiver of the spousal right must be signed after the marriage in order to be legally binding. Since ERISA and the Retirement Equity Act do not control IRAs, a waiver in a prenuptial agreement of any rights in the IRA owner’s IRA should be legally binding. If a prenuptial agreement intends to address retirement accounts and a spouse’s waiver of rights to either a qualified plan account, or he/she agrees to treat an IRA as the owner’s separate property, a couple of provisions should be added to the prenuptial agreement:
(i) while the surviving spouse has many rights under ERISA, if the surviving spouse violates the prenuptial agreement, e.g. the waiver is not signed after the marriage, and wrongfully retains the deceased participant’s account balance, the agreement should specify that there exists a cause of action against the surviving spouse for breach of contract by the deceased spouse’s family members who would have been named as qualified plan account beneficiaries; and
(ii) not only does the future spouse agree to waive his or her rights to the qualified plan balance as the ‘surviving spouse,’ he or she agrees to consummate that waiver through a lawful execution of a timely executed and filed waiver and consent of any and all surviving spouse rights to a joint and survivor annuity under ERISA in the presence of the plan administrator.
Conclusion: It is easy to assume that IRAs and qualified plan accounts, like 401(k) accounts are pretty much the same. They are from a taxable income perspective, but they are treated differently when it comes to the retirement account owner’s divorce.