Avoid adverse and unexpected tax consequences.
When representing a client going through a divorce, you must settle a number of differing property issues. Of particular concern are the special rules governing individual retirement accounts. The recent Tax Court memorandum decision in Kirkpatrick1 (discussed below) is a reminder that if the transfer of an IRA isn’t properly handled in relation to the divorce, it can lead to adverse, and likely unexpected, tax consequences.
The Rules
The Internal Revenue Code provides that the transfer of an individual’s interest in a qualified plan or IRA to his spouse or former spouse under a “divorce or separation instrument” isn’t a taxable transfer. Specifically, in relation to IRAs, IRC Section 408(d)(6) states that the transfer of an individual’s interest in an IRA to his spouse or former spouse under a divorce or separation instrument isn’t to be considered a taxable transfer, and such interest at the time of the transfer is to be treated as an IRA of such spouse and not of such individual.2 Regarding qualified plans, an alternate payee who’s the spouse or former spouse of the participant is treated as the distributee of any distribution or payment made to the alternate payee under a qualified domestic relations order (QDRO).3 That is, when the transfer is made to the former spouse pursuant to a divorce, the individual’s interest at the time of the transfer is treated as an account of the former spouse.
Two requirements must be met for the exception of Section 408(d)(6) to apply: (1) There must be a transfer of the IRA participant’s “interest” in the IRA to his spouse or former spouse, and (2) such transfer must have been made under an IRC Section 71(b)(2)(A) divorce or separation instrument.4
While a QDRO5 is required when transferring a portion of a qualified plan pursuant to a divorce, federal law doesn’t require one for IRAs because IRAs aren’t subject to the anti-alienation requirement applicable to qualified plans. Instead, the process of dividing an IRA in a divorce is referred to as a “transfer incident to divorce.” Generally, when splitting an IRA in such cases, the division is completed by working with the IRA custodian to: (1) change the name on the existing IRA to that of the former spouse, or (2) transfer the portion of the IRA awarded to the former spouse to the former spouse’s own IRA.
Divorce or Separation Instrument
As indicated, the transfer of a retirement plan must be made pursuant to a divorce or separation instrument. For IRA purposes, a “divorce or separation instrument” is a “decree of divorce or separate maintenance or a written instrument incident to such a decree.”6
Private Letter Ruling 9344027 (Aug. 9, 1993) highlights an example of a transfer that doesn’t satisfy this requirement. In this ruling, married taxpayers separated and entered into a written separation agreement. Under the agreement, one-half of the husband’s IRA was to be transferred to an IRA in the wife’s name. This action, however, was being done pursuant to a private, written separation agreement. The couple wasn’t divorced and wasn’t contemplating filing for divorce, nor were they legally separated. There was no assertion on the part of the taxpayers that the IRA division was in the nature of a transfer under a divorce or separation instrument as defined in the IRC.
The taxpayers requested a ruling that the IRA distribution to the wife wouldn’t be taxable to the husband but would be treated as the wife’s property. The IRS, however, ruled that this wouldn’t qualify as a nontaxable transfer because the proposed distribution was to have been made pursuant to the terms of a private, written separation agreement that wasn’t incident to a divorce or legal separation. There was no indication that the taxpayers intended to present their agreement to a court that had jurisdiction over their marital affairs for the court to enter a decree with respect to the separation agreement. Accordingly, the IRA distribution was taxable to the husband and wasn’t treated as the property of the wife. Practitioners should keep in mind that a separation agreement that isn’t “incident” to a decree of divorce isn’t sufficient to make the IRA transfer nontaxable.
Transfer of Interest in IRA
Even if there’s a proper decree of divorce or separate maintenance or a written instrument, a transfer pursuant to such document can still trigger income tax if the transfer isn’t properly completed.
For example, if one spouse is ordered to pay the other spouse cash in the divorce settlement and then takes a distribution from his IRA to satisfy such requirement, it results in a taxable transfer. The reasoning behind this conclusion is that the order is for cash rather than a portion of the IRA. Harris7 highlighted this result. In that case, the husband was awarded three IRAs under the divorce decree but he was also ordered to pay his former wife’s tax liability from a prior tax year. Because it was the only money available to him at the time, the husband withdrew funds from the IRAs and sent his former spouse a check so that she could satisfy her income tax liability. The husband argued that he shouldn’t be taxed on the IRA distribution because he transferred the money to his former spouse, as required by the divorce decree. The court stated, however, that because the divorce decree didn’t require that the husband transfer an interest in the IRAs to his former spouse, and in fact had allocated the IRAs to the husband, Section 408(d)(6) wasn’t applicable. That is, the IRAs weren’t transferred to his former spouse pursuant to the divorce decree.
In addition, if a taxpayer takes a distribution from his IRA and pays the cash to his former spouse to satisfy the requirement to pay a portion of his IRA to the spouse, that would also be a taxable distribution. The recent Kirkpatrick case illustrates this situation.8 In Kirkpatrick, the petitioner, John Kirkpatrick, was ordered in a divorce action to transfer $100,000 to an IRA titled in his wife’s name. To fulfill this obligation, John transferred money from his IRA to his checking account and subsequently wrote a check to his wife. On his income tax return for that year, John reported the IRA distribution as nontaxable. John asserted that nothing in Section 408 or the regulations thereunder offers any specific guidance on the timing of a transfer for it to qualify under the Section 408(d)(6) exception. Therefore, he maintained, it’s logical to assume that any such transfer is nontaxable so long as it occurs in a timeframe beginning with the issuance of a written instrument, such as the court order, and through a judgment of absolute divorce. John pointed out that this was the case here, because his payments were made after the order was issued but before the divorce was finalized. John further argued that the fact that the funds passed through his checking account on the way from him to his spouse’s IRA should have no bearing on the taxability of the exchange because the funds were moved within the allowable time limit for this type of transaction.
The Internal Revenue Service argued that John didn’t transfer any interest in his IRAs to his spouse as no IRA was opened in her name, nor was there any transfer of funds from John’s IRAs to any IRA owned by his spouse. The IRS pointed out that the Tax Court in the past has held that Section 408(d)(6) doesn’t apply to proceeds from an IRA cashed out and paid pursuant to a divorce order or judgment or otherwise transferred to a nonparticipant spouse.9
The respondent further argued that the petitioner didn’t comply with the order’s terms because the order required him to transfer in a nontaxable transaction $100,000 into an IRA titled in his wife’s name within 14 days of the order’s entry, which he failed to do. Thus, the respondent argued, the transfers shouldn’t be considered as made under a divorce or separation instrument or written instrument incident to such. The respondent further argued that the primary question is whether there was a transfer of an IRA interest and not whether the distribution and transfer of IRA funds occurred within a certain time.
The court agreed with the IRS and held that the IRA distribution wasn’t a nontaxable transfer incident to divorce but instead was taxable income to John. Pointing to the two requirements for meeting the Section 408(d)(6) exception, the court clarified that “interest” isn’t synonymous with the money or other assets held in an IRA and that withdrawal of funds from an IRA extinguishes the owner’s interest in that IRA or the appropriate proportion thereof. The court found that, in this case, there wasn’t a transfer of John’s interest in the IRAs to his spouse.10
To avoid taxation, advise similarly situated taxpayers to have the name of the IRA changed to the name of the former spouse or to directly transfer the funds to the spouse’s own IRA. As highlighted in this case, such taxpayers shouldn’t cash out a portion of the IRA and then write a check to their former spouse. Structuring the transaction in that manner wouldn’t fall under the exception of Section 408(d)(6).
Early Distribution Penalty
Another issue that can come into play with divorces involving IRAs relates to the early distribution penalty under IRC Section 72(t). As noted above, when an IRA transfer is made to the former spouse pursuant to a divorce, the individual’s interest at the time of the transfer is treated as an IRA of the former spouse. Once that occurs, if the former spouse is under age 59½, any distributions he takes will subject him to the early distribution penalty unless an exception under Section 72(t) applies. Accordingly, give careful thought to whether, from a tax standpoint, an IRA is the best asset to award a former spouse if it’s anticipated that the former spouse will need IRA distributions before age 59½.11
On a related matter, one of the exceptions to the early distribution penalty is when the IRA owner takes a series of substantially equal periodic payments.12 Once such a series is started, it needs to continue until the later of five years or the IRA owner’s attainment of age 59½. Except under limited exceptions, no modification can be made to the series during that time without triggering the 10 percent early distribution penalty retroactively to the start of the series.
There have, however, been a number of private letter rulings allowing the participants to reduce their series of periodic payments in relation to their new account balance following a divorce. They’ve been allowed to reduce their payments because the IRA balance was reduced after the divorce. In PLR 200202074 (Jan. 11, 2002), for example, the taxpayer maintained an IRA from which he was taking a series of substantially equal periodic payments. During the period of the series, he and his wife divorced, and the wife was awarded one-half of the IRA. As a result, the taxpayer wanted to reduce his monthly distributions from the IRA by 50 percent. The taxpayer requested the IRS to rule that he could reduce his payments without it being considered a modification of his series of substantially equal periodic payments. The IRS allowed the taxpayer to reduce his payments without triggering a modification.
In similar cases, it’s recommended that the taxpayer get his own PLR before reducing his payments to avoid triggering the penalty for a modification, given that there’s no solid support for this under the tax law, and a PLR can only be relied on by the taxpayer who requested it.
Endnotes
1. Kirkpatrick v. Commissioner, T.C. Memo. 2018-20.
2. Internal Revenue Code Section 408(d)(6) and Treasury Regulations Section 1.408-4(g).
3. IRC Section 402(e)(1).
4. See Bunney v. Comm’r, 114 T.C. 259 (2000). In Bunney, the petitioner and his wife were divorced. The divorce judgment ordered that the petitioner’s individual retirement accounts be divided equally between both spouses. Subsequent to that order, the petitioner withdrew funds from his IRAs and transferred a portion of them to his spouse. The court held that the petitioner and not his spouse was taxable on the distributions because the petitioner didn’t transfer any of his interest in his IRAs to his former spouse.
5. See IRC Section 414(p).
6. IRC Section 71(b)(2)(A).
7. Harris, T.C. Memo. 1991-375.
8. Kirkpatrick, supra note 1.
9. See, e.g., Bunney, supra note 3.
10. See also Jones v. Comm’r, T.C. Memo. 2000-219. In this case, the petitioner and his wife filed for divorce. The couple subsequently prepared a draft marital settlement agreement that required the husband to transfer his interest in his IRA to the wife. In anticipation of this agreement and a few weeks before the draft was executed, the husband cashed out his IRA and endorsed the distribution check over to the wife. Shortly after that, the husband and wife executed the marital settlement agreement. The court held that the IRA distribution wasn’t excludible from the husband’s income because the distribution didn’t constitute the transfer of the husband’s “interest” in his IRA.
11. In light of the elimination under the Tax Cuts and Jobs Act of the federal tax deduction for post-2018 alimony payments, practitioners representing a retirement plan owner should also consider advocating for the award to a former spouse of an interest in a retirement plan rather than the payment of alimony.
12. IRC Section 72(t)(2)(A)(iv).