Dealing with IRAs in a divorce.

While divorce is certainly a part of American society, there is still a question of whether the tax law on divorce has kept up, especially as it relates to the division of individual retirement accounts (IRAs) and other retirement plans.

Qualified domestic relations orders (QDROs) apply to qualified retirement plans. By this means a pension or profit-sharing plan can be split between spouses without tax or penalty. The receiving spouse steps into the position of the participant spouse without currently taxing either party. Even if this division of the retirement account is done before age 59 1/2, there is no penalty on the division of one plan to another owner/beneficiary. An IRA is not a qualified retirement plan; it therefore is not afforded this QDRO protection.

Under Sec. 408(d)(6), however, the owner of the IRA can surrender all or part of his IRA to a spouse incident to a divorce and avoid current tax and penalty. To get this benefit, a taxpayer must surrender his IRA pursuant to a divorce decree or a written instrument incident to the divorce (such as a property settlement).

Sometimes a qualified retirement plan allows for in-service distributions. When a distribution is available, a QDRO may be detained by an uncooperative plan administrator or a divorce court judge. If the qualified retirement plan allows for in-service distributions, a plan participant may transfer his interest directly to an IRA and then make the necessary split in the account assets to each spouse. This transfer can be done in any of several ways. The owner of the retirement plan may transfer into an IRA just the amount he needs to give to the spouse; this new IRA can then be given to the spouse in its entirety. The owner of the retirement plan may also transfer all of his retirement benefits into one IRA; this IRA can then be split into two IRAs, with the respective spouse's name on the portion each is to receive. Another method is to transfer the retirement plan benefits into two IRAs; each IRA would contain the amount each spouse is entitled to receive under the divorce. The ownership of one IRA is then given to the recipient spouse.

Contributions to IRAs can be either deductible or nondeductible. In the case of an IRA split between spouses on divorce, what happens to its nondeductible contribution basis? It is not clear if the basis in an IRA can be split under any other method other than pro rata based on the amount of the IRA given to each spouse; the IRS probably will only accept a pro rata split. If a taxpayer maintains two or more IRAs--one containing tax-deducted contributions and the other containing nondeducted contributions--can the value of one IRA go to one spouse along with all the "nondeductible basis" and the value of the other IRA with no basis go to the other spouse? The probable answer is no. An individual may have as many IRAs as he chooses, but the "nondeductible basis" in all IRA accounts will be allocated equally to each dollar in all IRAs.

Attorneys handling divorces should be aware of this issue and the possible tax benefits. Accountants advising taxpayers about the tax considerations of their IRA investments should keep in mind how distributions from these accounts will be taxed in future years. Careful planning can match the withdrawal of money from IRAs to coincide with years of little or no other income. This can minimize the amount of tax that needs to be paid from IRA distributions. Without careful planning a taxpayer may be forced to withdraw more money than he intends just to get to the taxable portion of the IRA. Most of the time, advance planning is the best way to assure the best tax benefits.