Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

Taxpayers contemplating divorce are generally aware that their individual retirement account (IRA) and Qualified retirement plan (QRP) assets will likely be divided up as part of the divorce. IRAs and QRP accounts can be split in a tax-effective manner if this is done as part of the divorce decree or property settlement agreement. 

Sometimes when the taxpayer is getting along well with the soon-to-be-ex-spouse, the taxpayer may be tempted to transact a pre-divorce split of IRAs and QRP accounts. This is especially likely in a community property state where the taxpayer clearly understands the spouse will wind up with half of the account balances anyway, when all is said and done.

The taxpayer may think that, before the divorce, funds can simply be withdrawn from the taxpayer’s accounts and transferred tax-free into the spouse’s IRA or qualified retirement plan account. The taxpayer may also think that such pre-divorce do-it-yourself transactions will save legal and accounting fees. Although these ideas seem to make sense, nothing could be further from the truth. The danger level intensifies when the taxpayer functions as the trustee of his or her qualified retirement plan and therefore has the power to unilaterally act without the benefit of professional advice.

The truth is, amounts withdrawn by the taxpayer before the divorce will generally be treated as fully taxable distributions to the taxpayer. They will not be taxed to the other spouse who actually receives the funds; nor will they qualify for a tax-free rollover into the spouse’s IRA or QRP account. Instead, the taxpayer’s spouse will own the funds tax-free, because the tax is imposed on the taxpayer.

If the taxpayer is under age 59½ at the time of the withdrawal, the 10 percent premature withdrawal penalty tax will generally apply on top of the regular income tax liability. Finally, amounts cannot be withdrawn from QRP accounts except for reasons specified in plan documents. Satisfying the taxpayer’s desire to accomplish a pre-divorce split of marital assets is not one of those reasons, and a withdrawal could have the effect of disqualifying the taxpayer’s retirement plan.

The message in this article is simple. Proper planning is critical to achieve acceptable tax results when dividing up IRA and QRP assets in a divorce case. In this area, irreparable damage can result when tax advisers do not find out about transactions until after they have occurred.

Our office can assist with divorce tax planning to avoid surprise tax liabilities.