In a divorce, assets, which include cars and homes as well as savings, investments and retirement accounts such as IRAs, are typically divided equally between both spouses. Care should be taken in the division of IRAs, however, because there are serious tax implications involved in withdrawals from an IRA. Divorcing couples should make sure the right steps are taken for not only a fair and equitable distribution but also one the IRS approves.
The Internal Revenue Code (IRC) clearly states that premature IRA withdrawals are subject to a 10 percent penalty, as outlined in Section 72(t). IRS regulations also state that any dollar amount withdrawn from an IRA account in a given year is included in the gross income of the payee or distributor for that year.
However, the IRS makes an exception in cases of divorce when the assets of an IRA must be transferred or split between divorcing parties. The exception is considered valid only if there is a transfer of the IRA participant’s interest into the IRA account of the former spouse and if the transfer is made in accordance with a legal divorce or separation decree.
Most divorcing couples use the direct transfer method. With a direct transfer, the owner of the IRA orders a trustee of the IRA to transfer all of the required funds from the individual retirement account into an existing IRA that belongs to the former spouse. Another route is for the IRA owner to transfer his or her own IRA funds into a separate IRA account and leave the remaining balance behind. He or she could also request the trustees to complete a name change to the account, so it would henceforth belong to the former spouse.
Dividing an IRA must be done properly so the IRS recognizes the transfer and waives the taxes and fees associated with an IRA withdrawal. This applies the transfer routine or simple name change of the account holder to the recipient.
Both divorcing parties must agree to the transfer of assets, or the court must order the division. The divorce decree details the amount of IRA funds to be divided and the method of division. The divorce papers must reference that the transfer is being made pursuant to the divorce settlement terms and that it is meant to be a tax-free transfer under the Internal Revenue Code Section 408(d)(6).
Unlike pension plans, a divorcing couple does not need a QDRO to split an IRA or a Simplified Employee Pension (SEP) accounts, but care must be taken to avoid taxes and penalties.