An area where many individuals get into tax trouble is when splitting their Qualified Retirement Accounts (QRPs) and Individual Retirement Accounts (IRAs). Once you have come to the revelation that your assets must be split you may be tempted to start the process by making pre-divorce transfers prior to receiving an official judgment, decree or court order. This is especially tempting in community property states. Sometimes couples think they can save professional fees (legal and/or financial) by prematurely starting the process of dividing retirement assets. This can be a costly mistake. The same can be said for making post-divorce transfers.
The importance of this is best illustrated with an example.
Pre-Divorce IRA Distribution
Let’s assume that spouse A has $100,000 in an Individual Retirement Account (IRA) and spouse A and spouse B agree to split the IRA 50/50. Spouse A takes a distribution in the amount of $50,000 and then writes a check to spouse B for $50,000 and spouse B rolls-over the amount into his own IRA within the 60 day time limit. At the time that the distribution occurred, spouse A had not received a judgment, decree or court order requiring the distribution. This type of scenario would produce a very negative tax situation for spouse A and spouse B would receive a cash windfall of $50,000.
From a tax perspective, the initial amount withdrawn of $50,000 would be considered a fully taxable distribution to spouse A. Spouse A would be liable for the income taxes associated with this distribution. If spouse A is in the 25% tax bracket, the potential liability to spouse A would be $12,500. Also, if spouse A is under the age of 59 ½ at the time of withdrawal, an additional tax of 10% would be levied for a premature withdrawal which would equate to an additional $5,000 of taxes. Spouse A could end up with a tax bill for $17,500, give up $50,000 in retirement funds, and spouse B would receive $50,000 tax free. Technically, the rollover to spouse B’s IRA would not qualify. Spouse B would probably not complain in this situation, but it would be an inequitable solution.