Getting divorced is a major financial transaction not to be taken lightly. As such, it can have serious tax implications, including some pitfalls you’ll want to avoid. This is especially true when it comes to splitting up tax-favored retirement accounts between you and your soon-to-be ex. You’ll need to plan ahead to make sure the tax results turn out OK for you. This blog details the story.
Use QDRO to divide up qualified retirement plan accounts
Let’s say you have a qualified retirement plan at work, a profit-sharing or 401(k) plan; or if self-employed a small business retirement program like a “Keogh” pension plan or even IRAs. You’ll probably be ordered by the court to divide up the retirement account(s) between you and your ex as part of the divorce property settlement. However, doing it carelessly can create a real tax liability.
To divide up qualified retirement plan accounts the tax-smart way, you need to establish a qualified domestic relations order, or QDRO. What’s a QDRO? It’s simply some boilerplate language that should be included in your divorce papers. First and foremost, the QDRO establishes your ex’s legal right to receive a designated percentage of the retirement account balance or designated benefit payments from the plan. The good news is that the QDRO also ensures that your ex, and not the plan participant, 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 as most do. That way, your ex can take over management of the money while postponing income taxes until withdrawals are taken from the rollover IRA.
Bottom line: The QDRO is a fair deal for both you and your ex because it ensures that the person who gets retirement plan payouts will also owe the related income taxes.
Here’s the pitfall. If money from your qualified retirement plan gets into your ex-spouse’s hands without a QDRO being in place, as the plan participant, you face a potentially disastrous 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 add insult to injury, you may also get stung with a 10% penalty tax if this happens before you turn age 59½.
So make sure your divorce papers include the necessary QDRO language. Helpfully enough, the government even provides sample language in IRS Notice 97-11.
If you think this advice would be so well-known you would be wrong. There have been many court cases where individuals turned over retirement plan money to their ex-spouses without bothering with QDROs. Those individuals all wound up incurring big tax bills. Perhaps not fair, but the tax rules are often unfair to folks who don’t know what they are doing.
Be careful with IRAs too
You don’t need a QDRO to divide up an IRA between you and your soon-to-be ex without dire tax consequences. You can simply 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. As with a QDRO, this procedure ensures that your ex, and not you, will owe the resulting income taxes. These rules apply equally to traditional IRAs, Roth IRAs, SEP accounts, and SIMPLE IRAs (they are all considered IRAs for this purpose).
You still need to be careful here. The nice tax-free rollover deal only applies 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, again you’ll be treated as if you received the money, and you’ll be on the hook for the related taxes–even though you didn’t actually keep the money. Plus you’ll usually owe a 10% penalty tax if you’re under age 59½. To avoid this fate, you should never transfer IRA money to your ex in advance of a legal requirement in your divorce papers to do so.
In the end
You can divide up tax-favored retirement account money the tax-smart way or the tax-naive way. Unfortunately, some otherwise-competent divorce attorneys know little or nothing about taxes, which doesn’t work in your favor. You’ll need a good financial advisor or a tax professional that have handled numerous divorce-related tax issues to work with your attorney. The good news is, they generally don’t charge as much and you’ll actually save money in the process. While your attorney might be able to fill that role, don’t take it for granted.
For more information contact us at 845.563.0537 or Contact@CompassAMG.com
The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm. Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.