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Tax Court Rules on Divorced Taxpayer in IRA Withdrawal

Generally, amounts paid out from an IRA to a recipient under age 59½ are subject to a 10 percent penalty tax, in addition to regular income tax due on the distributions. However, the tax law provides several exceptions to the penalty, including certain distributions made pursuant to a divorce.

Nov 18th 2019
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A divorced taxpayer in a new Tax Court case, Rosenberg, TC Memo 2019-124, 9/19/19, failed to meet the letter of the law. The exception to the penalty tax is available for payments made under a “qualified domestic relations order” (QDRO).

The IRS defines a QDRO as “a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant.” It must contain certain specified information. An ex-spouse who receives QDRO benefits from an IRA is required to report the payments as if he or she were the IRA participant.

In the new case, the taxpayer’s marriage to his ex-spouse was dissolved by a judgment and property order in 2014. The order provided that his former spouse must pay him $10,000 from her retirement account as reimbursement for his payment to her of liquidated retirement proceeds during marriage.

The ex-spouse transferred retirement funds to the taxpayer in 2015.

However, instead of withdrawing the funds from her retirement account at Merrill Lynch and making a cash payment to him, she arranged for the funds to be transferred from her retirement account to an IRA that the taxpayer opened at Merrill Lynch. Within seven days of this transfer, the taxpayer withdrew the funds and closed the account.

Accordingly, Merrill Lynch issued a Form 1099-R to the taxpayer, reflecting a withdrawal of $9,875 ($10,000 reduced by a $125 withdrawal fee). He also withdrew $245 from an IRA he held at Fidelity Investments and received a Form 1099-R in 2016 from Fidelity showing this withdrawal. The taxpayer had not yet turned age 59½ at the time of the withdrawals.

On his 2015 tax return, the taxpayer reported the Fidelity withdrawal as income, but not the Merrill Lynch withdrawal. He did not report or pay the 10 percent penalty tax for early distributions for either withdrawal.

The tax law specifically excludes from the 10 percent penalty tax transfers as part of property settlements incident to divorce or separation pursuant to a QDRO. But, despite the claims of the taxpayer, the withdrawal does not fit into that exception.

Alternatively, the taxpayer argued that the Court should

disregard the Merrill Lynch account and the intermediate steps of the transfers from his former spouse’s retirement account to his IRA and his immediate withdrawal from that account

treat the transaction instead in substance as a payment of cash from his former spouse to him as prescribed by the property order.

This doesn’t fall into the list of statutory exceptions to the tax penalty for early IRA withdrawals either. The Court wasn’t going to create a new exception. Therefore, it upheld the determination that the Merrill Lynch withdrawal, as well as the Fidelity withdrawal, constitutes taxable income that is subject to the 10 percent penalty tax.

Moral of the story: This tax result could easily have been avoided by establishing a QDRO that would provide payments exempted from the penalty. Or the taxpayer could have waited until after age 59½ to withdraw the funds or make other arrangements. Clients should be made aware of the tax implications when a divorce agreement is being hammered out.

Related Articles

The Case for Deferring Monies into a Roth IRA

Advice for Dividing IRAs in a Divorce

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