When a couple divorces, it is not unusual for the retirement plan of one or both spouses to be the most significant asset that must be divided. If the plan is a “Qualified Plan” such as a Defined Benefit or 401k, the plan may be divided between the spouses using a Qualified Domestic Relations Order (QDRO).
A QDRO not only allows for the tax-free division of the plan’s assets, but distributions from Qualified Plans pursuant to a QDRO are not subject to the 10% penalty for early withdrawal. Regardless of the age of the spouse receiving the QDRO distribution, no early withdrawal penalty applies (IRC Section 72(t)(2)(c)).
However, the tax treatment of the division of IRAs in divorce is vastly different than that of Qualified Retirement Plans. Although one could make the argument that a QDRO could provide for the tax-free division of an IRA in a divorce, there is no requirement that a QDRO be in place to avoid tax when dividing an IRA in divorce proceedings (IRC Section 408(d)(6)).
Even if a QDRO is in place, it will absolutely not protect you from the 10% early withdrawal penalty from a nonqualified retirement plan such as an IRA (IRC Section 72(t)(3)(A)). The 10 percent early withdrawal penalty applies (subject to certain exceptions) to distributions that are taken from IRAs and other retirement plans when you are under age 59 ½.
Doing it Right
The surest way to avoid tax and the early withdrawal penalty on the transfer of an IRA in a divorce is to make certain that the transfer complies with the provisions of IRC Section 408(d)(6). In a landmark case (Michael G. Bunney v. Commissioner, 114 TC No.17, April 10, 2000) the tax court opined that there are two requirements that must be met in order for IRC Section 408(d)(6) to apply:
There must be a transfer of the IRA participants “interest” in the IRA to his/her spouse or former spouse, and
Such transfer must be made under a IRC Section 71(b)(2) divorce or Separation Instrument.
The latter requirement can be somewhat technical (See IRS Private Letter Ruling 9344027), but in short the instrument must be ratified by a court of competent jurisdiction.
The tax court also pointed out in the Bunney case, that IRS Publication 590 (since superseded) described two commonly used methods of transferring an interest in an IRA.
Changing the name on the IRA to that of the nonparticipant spouse.
Directing the trustee of the IRA to transfer it to the Trustee of an IRA owned by the nonparticipant spouse.
As of the date of this writing, most practitioners consider this sound advice.
The Take Home
A QDRO is not required to divide an IRA free of tax and penalty in a divorce.
A QDRO will not protect you from the 10 percent penalty for early withdrawal when dividing an IRA in a divorce.
For your client to safely transfer interest in an IRA in a divorce, they must do so under a court ordered IRC Section 71(b)(2) divorce or separation instrument, and follow the guidelines in IRC Section 408(d)(6).
David Ellis is the managing partner of Ellis & Ellis, CPAs, Inc. located in Pasadena, California. He has over 30 years of experience in the practice of Divorce, Trust/Estate, and other family tax matters