Divorce and Retirement Accounts – Question of the Month

By Jeffery Levine, IRA Technical Expert  
Follow Me on Twitter: @IRAGuru4EdSlott

This month, the Ed Slott and Company IRA Discussion Forum featured a number of questions about how IRAs and other retirement plans can be protected in a divorce. Want to know how? Read on to find out…

Divorce can often take an emotional and financial toll on a family. But far too often, the financial toll is made worse by poor decision making, foolish actions or simply, just poor advice. Just like many other areas of tax planning, some of the most costly mistakes in this process involve IRAs and other types of retirement accounts. Below is a brief overview of the procedures that should generally be followed when splitting retirement accounts pursuant to a divorce so that you can avoid many of the common mistakes.

IRAs (Including Roths, SEPs and SIMPLEs) – First off, you need to know how IRAs are split in a divorce. You can’t simply take a distribution and give it to an ex (or current) spouse. Not only would those funds no longer be in an IRA, but YOU would get stuck with the tax and, if applicable, the 10% penalty for early distributions. That’s not good for anyone. Instead, if an IRA is to be split as part of a divorce, the split must be included in the divorce agreement. That document is then given to the IRA custodian. The funds should be transferred directly to the ex-spouse’s account. Then, if they take the money outright, at least THEY will be responsible for any applicable tax and penalties. There is no exception to the 10% penalty for IRA funds received pursuant to a divorce.

Qualified Plans (i.e. 401(k)s) – Like IRAs, funds from a qualified plan cannot be distributed and given to a spouse without significant tax ramifications. But unlike IRAs, qualified plans cannot be split by a divorce agreement. Instead, a special court order known as a qualified domestic relations order, or QDRO for short, is needed. Once the court has issued this document, it must be forwarded to the plan’s administrator, which must review the order. Upon accepting the order, the receiving spouse, known as the alternate payee, will have different options depending on the plan’s unique provisions.

For defined contribution plans like a 401(k), one option is usually to take the funds directly from the plan. Although this would be a taxable distribution, funds received from a plan pursuant to a QDRO are NOT subject to the 10% penalty for early distributions, as there are subject to a special exception. Another option in many cases, is to roll the funds over to an IRA. If the receiving spouse is over 59 ½ or doesn’t need the money until they will be, this is usually a good choice. But be careful, once the funds are rolled to an IRA they are no longer exempt from the 10% penalty on early distributions, so any funds taken before age 59 ½ would be subject to tax and a penalty (unless another exception applied).

Have more questions?? Want to see what other people are asking? Check out the Ed Slott and Company IRA Discussion Forum.