Individual retirement plans and divorce settlements.

When reviewing a divorcing couple's assets, it is not uncommon to discover that substantial assets have been invested in qualified retirement plans and individual retirement accounts (IRAs). Since retirement plans may become part of the divorce proceedings, care must be exercised in transferring these retirement benefits, due to the complexity and rigidity of the underlying rules governing their transferability.

In particular, the transfer of an IRA presents a unique situation. An IRA is not a qualified plan and therefore is an exception to the qualified domestic relations order (QDRO) rules. A common misconception is that a QDRO can be used to divide IRAs. Unfortunately, QDROs cannot be used with respect to IRAs and apply only to Sec. 401 plans.

However, Sec. 408(d)(6) treats the transfer of all or part of an IRA to a former spouse as a nontaxable event if certain conditions are satisfied. The transfer must result from a decree of divorce or separate maintenance, or a written instrument incident to a divorce. The transfer is not treated as a taxable distribution for income tax purposes to either spouse. Sec. 408(d)(6) provides this nontaxable treatment only if the funds are transferred from one spouse's IRA into the former spouse's IRA. Hence, if the funds pass from one spouse's IRA directly to the former spouse (i.e., rather than to the former spouse's IRA), that distribution will be taxed to the transferor spouse.

In addition, the transfer of an IRA is not exempt from the 10% penalty tax under Sec. 72(t). This exemption applies only to those who use a QDRO (Sec. 72(t)(2)). Thus, any withdrawal of the IRA by the recipient spouse as an early distribution (i.e., prior to attaining age 59 1/2) would be subject to a 10% penalty.

Before finalizing a divorce settlement, couples and their advisers should exercise caution in structuring IRA transfers. IRA transfers between spouses are only addressed in the concept of divorce; accordingly, the timing and nature of the transaction are critical. If the transfer of an IRA from one spouse to another occurs prior to or after the divorce settlement (and is not incorporated in the divorce decree), it appears likely to be taxed as an early distribution to the transferor. To avoid current taxation on the transfer, the divorce decree should specify that the IRA transfer is pursuant to the divorce; the IRA should be transferred from the transferor spouse's IRA account to the former spouse's IRA account. Such a trustee-to-trustee transfer pursuant to a divorce decree may ensure that a non-taxable event has occurred.

From Thomas M. Brinker, Jr., CPA, PFS, MS, Tax Partner, Brinker, Simpson & Company, L.L.P., Springfield, Penn. (not affiliated with AFAI)