Divorce, Retirement Plans and Taxes

: This article originally appeared in Today’s CPA and is reprinted here with
permission from the Texas Society of Certified Public Accountants.

While division of property incident to divorce is generally tax-free, retirement plans can be the exception to the rule, if not handled correctly. CPAs can play an important role in helping clients avoid paying unexpected taxes, penalties and fees related to retirement plans when they divorce. In addition, the value CPAs give clients can go beyond tax issues to help facilitate a smooth and effective division of the retirement assets.

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Dividing and transferring qualified plans

When dividing or transferring ownership of retirement plans in divorce situations, CPAs and clients need to be aware that qualified plans and Sec. 457 plans are treated somewhat differently than IRAs. Qualified plans require a legal document called a QDRO (Qualified Domestic Relations Order).

Ownership

Even in community property states, when divorcing, there is no joint ownership of retirement plans for tax purposes. The employee-spouse who participated in the retirement plan (the participant) is considered the sole owner for tax purposes until the plan has been divided or transferred pursuant to a divorce. This contrasts with the concept in estate planning, where the surviving spouse in a community property state has rights to half of the estate, including the retirement plan of the deceased spouse.

Necessity of the QDRO

Since the Retirement Equity Act of 1984, QDROs are required in order to recognize the existence of a non-participant spouse’s (alternate payee’s) right to receive all or a portion of the benefits payable from the participant’s retirement plan. The QDRO serves two main purposes. First, an approved QDRO is necessary to transfer ownership, in whole or in part, to the alternate payee. Second, an approved QDRO is needed to avoid taxation upon transfer to alternate payee. If the Participant takes a distribution from the plan without a QDRO and gives the distribution to the ex-spouse, the distribution will be taxable to the participant. This is true even if the divorce decree states that the ex-spouse should get the distributed amount from the plan. On the other hand, if the retirement plan is transferred using a QDRO, the transfer will be tax-free.

What is a QDRO?

A QDRO is a legal document that determines what benefits from the qualified plan will go to the alternate payee and what benefits will remain with the participant. A major limitation of a QDRO is that it cannot demand that the plan provide any benefits that are not already provided in the plan document itself.

Each QDRO must conform to specific rules determined by the administrator of the qualified plan (the plan administrator, e.g., Fidelity or Teacher Retirement System). No two QDROs are alike. A separate QDRO must be written for each plan that is to be divided or transferred.

QDRO approval

The plan administrator must approve the document before the alternate payee is given any rights to the retirement account. Most couples believe the divorce decree carries enough authority to divide all their assets, including the qualified plan accounts. This is not true.

If the alternate payee is not aware of the necessity of an approved QDRO, years can pass before learning he/she has no rights to those funds. By the time the alternate payee discovers the problem, correcting it can be expensive. QDRO approval is a lengthy process. Expect it to take two months or longer. Frequently a QDRO is returned by the plan administrator for corrections, which further delays the approval.

QDRO biases

QDROs are often biased. Due to the complexity of the document, a QDRO can favor one spouse. The divorce decree may generally state the plan is to be divided “equally,” however, the QDRO defines just what “equal” means. The QDRO, not the divorce decree, will determine each spouse’s share of the retirement benefits.

What this means for a client is that he/she should have an experienced advocate involved in drafting the QDRO. Either party’s attorney can draft the document. If a client’s spouse hires an attorney to draft it, the client should have his/her own lawyer review the QDRO. The review will identify the biases so they can be amended or considered in the settlement.

After QDRO implementation

After the QDRO is in effect, the participant’s remaining share will not change in form. The remaining portion of a defined benefit plan will still be in the form of a defined benefit upon retirement. The remaining portion of a defined contribution plan will still be in the form of an investment account.

For the alternate payee, the situation is not quite the same. Usually, the portion of a defined benefit plan the alternate payee receives will still be in the form of a series of payments upon his/her retirement. Some plans will allow the alternate payee to take his/her portion of a defined benefit plan in a lump sum.
Defined contribution plans give the alternate payee distribution choices. The alternate payee can transfer the amount to a rollover IRA or take a lump sum distribution. Some plans allow the alternate payee to maintain an account with the plan.

If the alternate payee takes a lump sum, there is a potential tax trap. The lump sum payment must be rolled over into an IRA within 60 days to avoid being treated as a taxable distribution to the alternate payee. The problem is that the plan administrator is required to withhold 20 percent of the distribution, so the alternate payee receives only 80 percent of the distribution. To avoid taxation, he/she must deposit 100 percent of the distribution amount in a rollover IRA. This means that if the alternate payee cannot deposit additional cash equal to the 20 percent withholding to deposit in the IRA, he/she will owe tax and possibly penalty.

Dividing and transferring IRAs

Although transferring or dividing a traditional IRA or a Roth IRA incident to a divorce does not require a QDRO, it still requires some care. If not done correctly, the account owner or transferor (not the transferee) will pay unnecessary taxes and penalties. (Coverdell Education Savings Accounts, formerly Education IRAs, are not discussed here because they are not retirement accounts.)

Timing issues

Transfer of an IRA to the ex-spouse should be made after the divorce is final. If the account owner transfers part or all of an IRA before the divorce is final, he/she will be taxed on the distribution and possibly incur the 10 percent early distribution penalty. Although transfers incident to divorce are tax-free, a transfer cannot be incident to the divorce until the divorce has taken place. After a divorce, an account owner should transfer an IRA in a timely manner. If a divorce decree does not address the division of an IRA, then a transfer to the ex-spouse will be considered a taxable distribution to the account owner if transferred more than one year after the date of divorce.

Transferring the IRA

An IRA transfer needs to be done via direct transfer (trustee-to-trustee). The 60-day rollover rule does not apply to distributions incident to divorce. If the account owner takes a distribution from the IRA to give to the ex-spouse, he/she will be taxed on it. Therefore, the distribution should never be in the form of a check payable to a person.

When making transfers of IRA accounts pursuant to divorce, there are two ways to do so:

• Keep the name on the original account
• Change the name on the original account

In the following examples, the wife is the original account owner and the husband is the transferee.

Keep Name on Original Account: If 100 percent of the account is being transferred to the husband, he sets up a new IRA account to receive transfer. If the IRA is being divided, the husband’s portion must be transferred to his new IRA account, leaving the wife’s portion in her original account. This is the most common method of transferring.

Change Name on Original Account: If 100 percent of the account is being transferred to the husband, then the name on the existing account can simply be changed to that of the husband. If the IRA is being divided, the wife can transfer her portion to a new IRA account, leaving the husband’s share in the original account. The name on the original account can then be changed to that of the husband. This method tends to give the original account owner more control over the transfer.
The of an IRA is transferred to the transferee is treated as the original account owner for his portion of an IRA is transferred to him. For example, he keeps the original tax basis of his portion as his own basis. It is important for him to have copies of the applicable records of the original account.

Saving fees on QDRO drafting

Dividing retirement accounts using the least number of QDROs possible can save a client significant legal fees. It is common for a divorcing couple to have two or more retirement accounts that would require a separate QDRO for each division or transfer. Instead of splitting up every account, accounts can be transferred in their entirety to the alternate payee or wholly remain with the participant.

Example: Betsy and Henry are divorcing. Henry is the participant in four qualified plans: a Keogh, a 401(k), a 403(b) and a defined-benefit pension plan. The combined present value of the Keogh, the 401(k) and the 403(b) is roughly equal to the actuarial present value of the defined-benefit pension plan. Betsy and Henry can reduce legal fees by allocating entire accounts among them. Henry can keep the Keogh, the 401(k) and the 403(b) while Betsy is awarded the defined-benefit pension plan. They will not need a QDRO for the plans Henry keeps because Henry is the participant. Only one QDRO would be required for the transfer of the defined-benefit plan to Betsy. This would be a particularly effective if Betsy were not interested in managing investments because she will not need to make investment decisions regarding the defined-benefit pension plan account.
If the divorcing couple has both a qualified plan and an IRA, an alternative to drafting a QDRO is to leave the qualified plan account with the participant and give the spouse the IRA. This would avoid a QDRO altogether.

If the couple has a qualified plan account that can be rolled over immediately to an IRA, the couple can avoid the need for a QDRO by agreeing to have the participant roll the qualified plan account into a rollover IRA. Once this is done, they can split the IRA under the terms of the divorce decree without the cost and delay of a QDRO.

Beware: This tactic comes with a risk for the alternate payee. If the participant drags his/her feet in rolling over the IRA, the alternate payee can be forced to wait indefinitely to gain control over his/her share of the retirement funds.

Example: Sue and Butch have agreed to use this strategy on Butch’s 401(k) from his previous employer. The divorce decree states that Butch will roll over the account into an IRA and then transfer the entire account to Sue’s IRA. The divorce becomes final. The months go by and Butch has not rolled over the account. At considerable expense to her, Sue might have to hire an attorney to force Butch to roll over the account. In the meantime, she does not have control over the investments in this account. If Sue had insisted on a QDRO to divide the account, instead of rolling it over to an IRA, her attorney could have helped follow up on the implementation of the QDRO. This plan would have cost more initially, but in this case, it would have been the smart thing to do.
Some employers (especially state employee and teacher retirement plans) offer or require sample QDROs to be used by their participants. While using the sample QDRO may save time, it is important to work with an expert who is familiar with the sample QDRO. Many times these QDROs are written in favor of the participant, and some do allow limited changes to the QDRO in favor of the alternate payee. The changes can produce a significant difference over the sample wording.

Getting cash out of the accounts

Divorcees often need cash to pay professional fees, obtain housing, or pay off large debts. Retirement accounts might be a source of desired cash. When using an IRA as a source of cash, the divorcee needs to take the distribution after the IRA has been split up. When using a qualified plan as a source of cash, the divorcee needs to take the distribution during, not after, the plan account transfer.

IRAs

If needed cash will come from an IRA and the divorcee is not yet 59½ years of age, the divorcee/account owner will incur 10 percent early distribution penalty unless he/she can take advantage of any of the penalty exceptions. Does the account owner have unreimbursed medical expenses that are more than 7.5 percent of her adjusted gross income? If so, some of the withdrawal can be used to pay for these, avoiding the 10 percent penalty. If the account owner has children in college, the distributions can be used to pay for qualified higher education to avoid the 10 percent penalty. If the distributions are used to pay for medical insurance, money can be taken out penalty-free. If the account owner is disabled, funds can be taken out penalty-free. Other exceptions include using up to a $10,000 distribution to buy a home if the account owner has not owned a home within the past two years. Finally, the account owner can consider taking the withdrawals in substantially equal distributions over the longer of five years or until the account owner reaches age 59½.

Qualified plans

If a qualified plan allows a lump sum distribution, the alternate payee can get cash from his/her share of the plan without incurring the 10 percent early distribution penalty per Sec. 72(t)(2)(C). When submitting the QDRO for approval, the alternate payee must ask the plan administrator for a lump sum (partial or whole) distribution. This request does not go in the QDRO. When the plan administrator transfers his/her portion, the alternate payee will receive part of it in a check. The remainder will be deposited in his/her IRA. While this method avoids the penalty, the potential delays in the QDRO approval causes the timing of the receipt to be highly uncertain.

Timing of withdrawals

Smart timing of withdrawals can reduce income taxes. Since the distributions are taxable transactions, they will be taxed in the year received. The divorcee should try to spread the distributions over two or more tax years, if possible.

The CPA’s significance

While your divorcing client is in the throes of emotional strain, a CPA can be the stable and objective advisor. By becoming familiar with the details of dividing retirement accounts, a CPA can provide financial advice that will be beneficial to clients for the rest of their lives.

References

• IRC Sections 408 and 408A govern traditional and Roth IRAs
• IRC Sections 72, 401, 402, and 414 govern the qualified plans discussed herein

This article originally appeared in Today’s CPA and is reprinted here with
permission from the Texas Society of Certified Public Accountants.

© Tracy Stewart · tracy@tracystewartcpa.com · 979.324.8179 · 426 Tarrow Street, Suite 101 · College Station, TX 77840