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IRA garnished for child support subject to tax plus penalty.

In Vorwald, TC Memo 1997-15, the Tax Court recently ruled that the garnishment of a taxpayer's individual retirement account (IRA) pursuant to a judgment for child support arrearages was includible in his gross income and subject to the 10% early distribution penalty. Unlike qualified pension plans under Sec. 401, state law determines whether IRAs can be distributed to creditors of the IRA owner.

According to Sec. 408(d)(1), IRA distributions are included in the distributee's gross income as specified in Sec. 72. (There is an exception for amounts rolled over within 60 days.) Sec. 72(e)(2) requires IRA distributions to be included in gross income except to the extent of any nondeductible IRA contributions. Sec. 72(t)(1) imposes a 10% penalty on distributions from qualified retirement plans. There are several widely applicable exceptions to this penalty, none of which applied to the situation in Vorwald. The definition of "qualified retirement plans" for purposes of the 10% penalty includes IRAs.

Sec. 408(d)(6) allows tax-free transfers of an interest in an IRA to a spouse or former spouse pursuant to a divorce or written separation agreement. After such a transfer, the transferee spouse is the owner of the IRA and will be taxed on any distributions. However, Sec. 408(d)(6) transfers do not qualify as alimony because alimony, which is deductible by the payer under Sec. 215, must be included in the recipient's gross income under Sec. 71. IRAs are not affected by the qualified domestic relations order (QDRO) provisions of Sec. 414(p). QDROs cover the assignment of an interest in Sec. 401 and Sec. 403(b) pension plans to spouses, former spouses or children. They are an exception to the general rule of Sec. 401(a)(13) prohibiting the assignment (transfer) of interests in Sec. 401 pension plans.

In Vorwald, a $10,670 judgment payable to his former spouse Kathleen was entered against Mark Vorwald for child support arrearages. In a 1992 garnishment proceeding, a credit union was ordered to pay $8,483 from Mark's IRA to Kathleen for the child support, which it did. Mark did not become aware of the garnishment until the IRS notified him when auditing his 1992 return. The Service included the $8,483 in Mark's income and assessed the 10% early distribution penalty. (There was no evidence that he had made any nondeductible contributions to his IRA.)

The Tax Court ruled that the $8,483 was a distribution from the IRA to Mark and must be included in his gross income. The distribution was also subject to the 10% penalty. The transfer to Kathleen was the equivalent of a distribution to Mark because the transfer satisfied a legal obligation he owed to her. The court pointed out that the result would be the same if Mark had voluntarily paid a debt from his IRA. Finally, the Tax Court noted that Mark did not argue that Sec. 408(d)(6) applied to his situation.

Practitioners should be aware of Vorwald, as it applies to both parties in a divorce. For the party trying to collect child support (or alimony), state law should be consulted to determine if the former spouse's IRA can be attached to satisfy judgments for these debts. On the other hand, the party owing child support should try to satisfy this obligation out of funds that have already been taxed. Finally, property settlements involving IRAs should utilize the provisions of Sec. 408(d)(6), which were discussed earlier.
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Title Annotation:individual retirement account, Vorwald case
Author:Weatherwax, Roy C.
Publication:The Tax Adviser
Date:May 1, 1997
Previous Article:Employers may provide option to postpone minimum distributions.
Next Article:New self-correction policy for retirement plans.

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