Used to be the house was the biggest asset to split in a divorce. These days, it's the retirement account. Whether it's a pension or profit-sharing arrangement, 401(k), stock bonus plan or Keogh, it will probably be split up as part of your divorce property settlement. Same thing for IRAs. One misstep can lead to a tax disaster. Here's how to avoid the problems.
Retirement Plans at Work
You'll want to split up these accounts by using a qualified domestic relations order or QDRO. What's a QDRO? It's just some specific language that needs to be included in your divorce papers.
The QDRO establishes your soon-to-be-ex-spouse's legal right to receive a designated percentage of your qualified plan account balance or benefit payments. Since your ex becomes entitled to this money, he or she will also be responsible for paying the related income taxes when that money is received in the form of a pension, annuity or withdrawals. In effect, your ex becomes a co-beneficiary of your existing qualified plan account.
Alternatively, the QDRO arrangement permits your ex to withdraw his or her share and roll the money over into his or her own IRA (to the extent current withdrawals are permitted by the terms of the qualified retirement plan). The IRA rollover procedure allows your ex to take over management of the money while continuing to postpone taxes until funds are withdrawn from the IRA. Once again, the important point from your perspective is that your ex will be the one who owes the taxes.
What happens when your qualified retirement account money goes to your ex without a QDRO? Bad things. It's treated as a taxable distribution to you. This means you owe the IRS for money that actually winds up in your ex's pocket. Your ex will love this, because it's a tax-free windfall at your expense. On top of the income tax bill, you may also get stung with the 10% premature withdrawal penalty if you are under age 59 1/2. Truly, this is adding insult to injury.
So now you understand why you need a QDRO. To set one up, the language in your divorce papers must include the following:
To be safe, your papers should also specify that a qualified domestic relations order is being established under your state's domestic relations laws and Section 414(p) of the Internal Revenue Code.
There are a few other procedural details, so you should consult a tax professional with substantial divorce case experience to make sure all the required bells and whistles get included. Obviously, this must happen before the divorce papers are finalized. Do not assume your divorce attorney knows how to take care of this QDRO stuff. Most don't.
Now, if your qualified retirement plan accounts are with a major company, the plan administrator will usually make sure your divorce papers include proper QDRO language before allowing your ex to withdraw any money. But don't take it for granted.
The risk of a fiasco is highest when you work for a small outfit or manage the qualified retirement plan yourself because you are self-employed or the owner of the business. People in this position often fork over qualified retirement account money to their ex without a QDRO.
IRAs and SEPs
You don't need a QDRO to split up your IRA accounts, but you still need to be very careful. Here's the deal. You can roll over money tax-free from your IRA to an IRA set up for your ex if and only if the transfer is called for by your divorce property settlement. Then your ex can manage his or her IRA and defer taxes until money is withdrawn. At that point, your ex -- not you -- will owe the taxes.
This is what you want. So make sure your divorce papers include the following magic words: "Any division of property accomplished or facilitated by any transfer of IRA or SEP account funds from one spouse or ex-spouse to the other is deemed to be made pursuant to this divorce settlement and is intended to be tax-free under Section 408(d)(6) of the Internal Revenue Code."
If money from an IRA account set up in your name gets into your spouse or ex-spouse's hands in any other fashion, guess what? You are on the hook for any taxes. Plus you will generally owe the 10% penalty if this happens before you are age 59 1/2. Once again, this amounts to a tax-free windfall for your ex at your expense. The same rules apply to simplified employee pension (SEP) accounts, because they are treated as IRAs for this purpose.
This may all seem pretty simple. Evidently not. Rarely does a month go by without a well-publicized court decision involving tax controversies from divorce-related IRA payouts. How do people most commonly get into trouble? Some try to make predivorce rollovers from one spouse's IRA to the other's thinking this is a tax-free transaction. Nope. As explained, it will be treated as a taxable distribution to the IRA owner (the person in whose name the account is set up). Others try to satisfy postdivorce financial obligations to their ex by taking IRA withdrawals. Once again, this will always trigger an immediate tax bill for the IRA owner, even though the ex gets the money.
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