Qualified retirement plans are defined as plans for which an employer and/or employee contributes and are sanctioned in the Internal Revenue Code. The most common are 401(k), IRA, Roth IRA and 503(b) plans among others. When handling these types of retirement plans, there are a variety of situations to consider during a divorce. Failure to follow the rules will result in the transaction being treated as a taxable distribution.
401(k) and Similar Plans
To divide a 401(k) account or similar account as part of a property settlement, the parties must first obtain a Qualified Domestic Relations Order (“QDRO”).
To be a QDRO, an order must be entered into before there is a plan distribution to an alternate payee, which would be either the spouse or a child. It is not sufficient for an order to recognize the alternate payee’s rights after the distribution has been made. Specifically, a QDRO:
(1) creates or recognizes the existence of someone other than the plan participant, to receive all or a portion of a plan participant’s benefits payable under a plan
(2) relates to payment of child support, alimony, or marital property rights to a spouse, former spouse, child, or other dependent of the participant
(3) specifies information regarding the right for benefits to be paid to the participant’s former spouse, child or other dependent.
Rollovers and Lump Sum Distributions
The former spouse may be able to rollover the portion of the qualified retirement plan into an IRA just as the plan participant would be able to depending on the terms of the QDRO.
The spouse or former spouse can use the special rules for lump-sum distributions, if the benefits would have been treated as a lump-sum distribution had the participant received them. For this purpose, consider only the balance to the spouse’s or former spouse’s credit in determining whether the distribution is a total distribution. For information about the special rules, see Lump-Sum Distributions in Pub. 575.
Who Pays the Tax?
Benefits paid under a QDRO to a former spouse are taxed to that spouse. Benefits paid to a child or other dependent are taxed to the participant.
IRAs and Roth IRAs
IRAs Transferred as a Result of Divorce
In a traditional IRA, the transfer of all or part of an individual’s interest to a spouse or former spouse, under a decree of divorce, a separate maintenance or a written instrument incident to the decree, is not considered a taxable transfer. A QDRO is not required. The transfer of an IRA as part of a written divorce property settlement is not a taxable transaction.
Transfer Methods
The two commonly used methods of transferring IRA assets to a spouse or former spouse. The methods are:
- Changing the name on the IRA. If all the assets are to be transferred, you can make the transfer by changing the name on the IRA from your name to the name of your spouse or former spouse.
- Direct transfer of IRA assets. Under this method, you direct the trustee of the traditional IRA to transfer the affected assets directly to the trustee of a new or existing traditional IRA set up in the name of your spouse or former spouse.
If your spouse or former spouse is allowed to keep his or her portion of the IRA assets in your existing IRA, you can direct the trustee to transfer the assets you are permitted to keep directly to a new or existing traditional IRA set up in your name. The name on the IRA containing your spouse’s or former spouse’s portion of the assets would then be changed to show his or her ownership.
The same rules apply to a Roth IRA. Any limitations to which the IRA or Roth IRA were subject are also in effect for the transferred “new IRA” IRA. For example, the Roth five-year rule which says you cannot withdraw earnings tax-free until it’s been at least five years since you first contributed to a Roth IRA account applies to any Roth IRA rollover from that account.
Caution: If your former spouse is a non-resident alien the transfers described above are taxable. Certain transfers to trusts may be taxable.
Property transferred because of a divorce is tax-free, provided it is transferred within one year from the date of the divorce. In theory, most states do not have a time limit on property being transferred under a QDRO. However, delaying is not recommended because issues may arise.
IRA Contribution and Deduction Limits
All taxable alimony you receive under a decree of divorce or separate maintenance is treated as compensation for the contribution and deduction limits for traditional IRAs. You cannot deduct a contribution to a spousal IRA if the divorce is final before the end of the year.
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