This is a difficult question to answer because the IRS has not been particularly consistent with their letter rulings over the years. And the only guiding authority on this topic is those letter rulings. Here is a copy of some of them from the 72t website:

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Q. If I get divorced and transfer a portion of the payments to my ex-spouse, will I loose the exemption from the 10% penalty tax?

A. The transfer to a taxpayer’s spouse pursuant to a divorce decree of 50% of each of three separate IRAs owned by the taxpayer from which the taxpayer had already begun receiving “substantially equal periodic payments” did not result in a modification where the taxpayer’s spouse was two years younger and would commence receiving similar payments such that the total of periodic payments to the taxpayer and his spouse subsequent to the division would be substantially equal to the periodic payments received by the taxpayer prior to the division. PLR 9739044

In PLR 200027060, the IRS rules that a spouse after the divorce, that received a portion of the client’s IRA accounts that were being used to fund a SEPP, didn’t need to continue the payments since it was a transfer under Code section 408(d)(6). What about the client – did all the payments have to be continued out of what remained of his accounts?

Later in PLR 200050046 (with similar facts) the IRS ruled in favor of the taxpayer. “The reduction in the annual distribution from IRA 1 to Taxpayer A beginning in calendar year 2001, prior to Taxpayer A’s attaining age 59 1/2 , and assuming Taxpayer A has not died and has not become permanently disabled, will not constitute a subsequent modification in his series of periodic payments, as the term “subsequent modification” is used in Code section 72(t)(4), and will not result in the imposition upon Taxpayer A of the 10 percent additional income tax imposed by Code section 72(t)(1) pursuant to Code section 72(t)(4)(A)(ii).

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Re setting would not be an option, and from the cited rulings it appears that her chances of preserving her plan would be to reduce her distribution by 42% starting with the calendar year in which the IRA was partially transferred incident to the divorce. She would then need a 5329 on her return to claim the 72t exception code “02”. If the IRS objects she could pursue her own letter ruling, but it will cost her around $10,000 plus legal fees.

Due to the uncertainty factor, it is recommended that settlements avoid these IRA partitions until the plan ends or use other assets for the settlement.

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This is a gray area with the IRS.

However, the transfer of part of her IRA to the ex spouse is a non reportable transfer, ie there is no 1099R issued to her or the IRS. About the only way the IRS would suspect anything is that the year end balance of the IRA would be down sharply, but it is doubtful that the IRS looks at that figure in terms of a 72t plan.

There is probably more risk in continuing the same distribution if the IRS were aware of the settlement, but continuing the same amount would otherwise be expected by the IRS so it might result in her never getting an inquiry at all. Of course, it depletes her IRA much faster than reduction. In making the choice she might consider how many more years are left in her plan.

She should either make the reduction or continue as before, and should NOT make any other changes such as some intermediate amount. That way she would be using a method that makes sense and the IRS may have approved before rather than electing some even more untested approach.

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