Getting divorced is a significant financial transaction that can have adverse tax consequences, particularly when splitting up tax-favored retirement accounts. Here's how to plan for the optimal tax results for your situation.
Federal income tax rules allow divorcing spouses to divvy up IRAs without dire tax consequences. You just arrange for a tax-free rollover of money from your IRA into an IRA set up in your ex's name. Then, your ex can manage the rollover IRA and defer taxes until he or she begins taking money out of the account. This ensures that your ex, not you, will owe the resulting income taxes.
The rules apply equally to traditional IRAs, Roth IRAs, SEP accounts and SIMPLE IRAs. They're all considered IRAs for this purpose.
Though the rules seem simple, you need to be careful. The tax-free rollover deal applies only when your divorce agreement requires the rollover.
If money from your IRA gets into your ex's hands before or after the divorce without such a requirement, you'll be treated as if you received the money. That means you'll be on the hook for the related taxes — even though you didn't keep the money. Plus, you'll usually owe a 10% penalty tax if you're under age 59½. To avoid this pitfall, you should never transfer IRA money to your ex before a legal requirement in your divorce papers.
To divvy up funds in a qualified retirement plan between divorcing spouses — without incurring an unwelcome tax hit — you'll need to establish a qualified domestic relations order (QDRO). This boilerplate language in your divorce agreement may specify how to split up:
A QDRO establishes your ex's legal right to receive a designated percentage of your retirement account balance or designated benefit payments from your plan. The good news for you is that the QDRO also ensures that your ex, and not you, will be responsible for the related income taxes when he or she receives payouts from the plan.
The QDRO arrangement also permits your ex-spouse to withdraw his or her share of the retirement plan money and roll it over tax-free into an IRA (assuming the plan permits such a withdrawal). That way, your ex can take over management of the money while postponing income taxes until withdrawals are taken from the rollover IRA.
A QDRO is fair for both spouses. It ensures that the person who gets retirement plan payouts will owe the related income taxes.
However, beware, if money from your qualified retirement plan gets into your ex-spouse's hands without a QDRO being in place, you face a potentially negative tax outcome: You'll be treated as if you received a taxable payout from the plan and then voluntarily turned the money over to your ex. So, you'll owe all the taxes while your ex gets the money tax-free.
To make matters worse, the extra income from a sizeable taxable transfer of retirement account funds could push you into the current maximum 37% federal income tax bracket. It may also cause some or all of your investment income to be hit with the 3.8% net investment income tax (NIIT) and cause you to lose tax breaks due to income-based phase-out rules.
To add insult to injury, you might also get stung with the 10% early distribution penalty tax if this happens before you reach age 59½. So, make sure your divorce papers include the necessary QDRO language.
Emotional issues aside, settling the financial aspects of a divorce can be complicated, especially if the parties have been married for many years and have accumulated substantial net worth. Your financial and tax advisors can help you devise various settlement options — including asset allocations and support payments — that minimize potential taxes and meet other personal objectives.
Get in touch today and find out how we can help you meet your objectives.
