Transferring IRA Assets During Divorce

fig 11 05 2018 06 04 49 - Transferring IRA Assets During Divorce

In this article, we address divorce and transfer of Individual Retirement Account (IRA) Assets.  We focus on the Traditional IRA because the rules for transfers are more restrictive than for a Roth IRA.  (If you follow the rules for transferring ownership interests in Traditional IRA assets for Roth IRA assets, you should qualify for the tax free transfer process described below. )

The Internal Revenue Code provides that any “Distribution” from an IRA shall be included as gross income and taxed to the payee (typically the account owner) or distributee for federal taxation purposes.  In the case of divorcing individuals, the Internal Revenue Code permits an exception to this rule under section 408(d)(6) that will allow IRA owners to “Transfer” IRA funds tax-free if certain requirements are met.  It is important that each of the requirements are met, otherwise, the tax-free status will be lost.  The exception will only apply if these two requirements are met:

  1. There must be a transfer of the IRA’s interest from one spouse to the other spouse / ex-spouse, and
  2. The transfer must  have been made under a divorce decree, separate maintenance, or property settlement agreement  (divorce or separation instruments)

The Internal Revenue Service provides some guidance on two different ways to transfer an interest / ownership of an Individual Retirement Account.  These include:

  • Changing the name on the IRA – If you are required or have agreed to transfer your entire interest in your IRA, changing the name on the account to your spouse / ex-spouse would be considered an appropriate transfer of your ownership interest.
  • Making a trustee to trustee transfer (direct transfer) from one spouse’s IRA account to your spouse’s / ex-spouse’s new or existing IRA account.

Note:  It is important to distinguish between the concept of distributions and transfers.  The exception to the rule above specifically refers to transfers.  Distributions from an IRA are usually considered taxable events to the account owner.  There are several tax court cases and rulings related to improper distributions that were made with the improper expectation that they met the exception requirements.

Strategy

We recommend taking the following actions when it comes to splitting IRAs:

  • Include language in your divorce or separation instrument that states the following:  the transfer of Individual Retirement Account funds is intended to be tax-free under section 408(d)(6) of the Internal Revenue Code (IRC).
  • Do not take a distribution from an Individual Retirement Account to transfer an ownership interest.  Change the name on the account or utilize the trustee to trustee (direct) transfer method to transfer the ownership interest.
  • Do not make pre-divorce transfers from an Individual Retirement Account that is not specifically described in a divorce or separation instrument.
  • Do not make post-divorce transfers from an Individual Retirement Account that is not specifically described in a divorce or separation instrument.

Consider the following two examples, one taxable and one tax-free.

Taxable 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 their own IRA within the 60 day time limit. At the time that the distribution occurred, spouse A had received decree order requiring the transfer.  This would be considered a distribution to spouse A and would not qualify as a tax-free transfer because it does not meet the Internal Revenue Code exception under section 408(d)(6) which requires that the ownership interest transfer from one party to the other.  Since spouse A took a direct distribution from the plan, this would not be considered a transfer of his ownership interest.

Tax-Free IRA Transfer

Let’s assume that spouse A has $100,000 in an Individual Retirement Account (IRA) and spouse A and spouse B have agreed to transfer 100% ownership of the IRA from spouse A to spouse B in accordance with the property settlement.  Spouse A changes the name on the account to spouse B as owner of the account. At the time that the transfer (name change) occurred, spouse A had received a decree requiring the transfer.  This transfer would be considered a tax-free transfer because it met the Internal Revenue Code exception under section 408(d)(6) which requires that a judgment, decree or court order be in effect prior to the transfer occurring and that the ownership interest (name change) in the funds has transferred as well.  Spouse A would not have a taxable event due to the transfer and spouse B would receive the transfer tax-free as the parties had intended.

Note that IRA’s are not subject to Qualified Domestic Relations Orders (QDROs).