Considerations when Diving Individual Retirement Accounts in a Divorce
In a prior blog, we discussed dividing certain types of pension plans via Qualified Domestic Relations Orders (QDROs). Here, we will discuss the division of another vehicle often used to fund a person’s retirement: individual retirement accounts (IRAs).
An IRA is a form of individual retirement plan, provided by many financial institutions, that provides tax advantages for retirement savings. Two main types of IRAs, traditional and Roth, each provide discrete benefits.
Traditional IRAs offer tax-deferred growth potential. A person saving for retirement via a traditional IRA pays no taxes on any investment earnings until the funds are withdrawn from the account, presumably during retirement. Depending on a person’s income, the contribution may also be tax deductible. Deferring taxes generally allows for a potentially greater accumulation of wealth. Many retirees end up in a lower tax bracket than they were during their pre-retirement years, so the tax-deferral means their money may be taxed at a lower rate.
A Roth IRA, on the other hand, offers tax-free growth potential. A person saving for retirement makes contributions with money on which they have already paid taxes, and investment earnings are distributed tax-free in retirement (so long as a five-year waiting period has been met and the retiree is at least age 59½, or as a result of death, disability, or using the first time homebuyer exception). Since contributions to a Roth IRA are made with after-tax dollars, there is no tax deduction regardless of income.
Parties do not need a QDRO to split their IRAs. Instead, a parties’ divorce decree will address this property division.[i] If your divorce agreement requires you to give part of your IRA to your spouse, rather than cashing out your IRA and giving the proceeds to your spouse, you should ask your IRA custodian to transfer a percentage or fixed dollar amount to your spouse’s IRA. Otherwise, you would have to pay taxes on the entire distribution.
During a divorce case, parties sometimes settle issues piecemeal throughout the litigation. This happens when, for example, one issue ends up being impossibly contentious for the parties to resolve amicably, while other issues are more easily smoothed over. To that end, during the pendency of a divorce action (meaning prior to a divorce judgment being entered), parties may wish to transfer IRA funds between themselves pursuant to a Stipulation and Order. As long as an Order is in place, a party can issue a letter of instruction to the IRA holding company and the trustee; the transfer will be a non-taxable event under IRC §1041.[ii]
In any case, if you receive a portion of your ex-spouse’s IRA, you should roll it into your own IRA to avoid taxes and early-withdrawal penalties. Similarly, if you receive a portion of your ex-spouse’s Roth IRA, you should transfer it directly into your own Roth IRA to preserve its tax-advantaged status.
Because of the different ways certain accounts are taxed, it is important to take into consideration the future taxes that may be due on accounts during any property division negotiations in a dissolution case. When in doubt about the tax consequences of the division of property in your dissolution proceeding, best practice dictates that you seek the advice of an experienced family law attorney, and perhaps a CPA as well. Remember, a traditional IRA and a Roth IRA containing the same amount of money today are not equal in terms of what they will be worth when distributed in retirement, and that difference must be taken in account when dividing such property in a divorce.
[i] Internal Revenue Code § 1041 (a) states the general rule as follows: “No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)–(1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce.”
[ii] Internal Revenue Code § 1041 (c) states that “For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer–(1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.”