Distributing an IRA in a divorce – can it be done without immediately paying taxes? A FAUXDRO may be the answer.
By Barbara Murray, Real Estate and Tax Lawyer
An Individual Retirement Account (“IRA”) is a personally-owned retirement plan which an individual establishes. There are three types of IRAs – traditional, rollover, and a Roth IRA.
For a quick refresher, in a traditional IRA, the contributions may be tax-deductible, and the earnings are tax-deferred until the time the funds are distributed. Contributions to a Roth IRA are not tax-deductible and generally the principal and earnings are distributed tax free. Annual distributions from a traditional IRA are required once an individual attains their required beginning date, while there is no minimum lifetime distribution requirement for a Roth IRA. Generally, a rollover IRA comprises funds distributed from a qualified plan. A rollover IRA takes on the same characteristics of a traditional IRA, so that earnings are tax-deferred and all distributions are taxable.
An IRA may be considered a marital asset subject to equitable distribution in a divorce or separation. So, how can an IRA be distributed to the spouse of the IRA holder?
Taxation of Distribution
There is a provision in Section 408(d)(6) of the Internal Revenue Code (“Code”) that addresses distributions of an IRA incident to a divorce or separation. In order to accomplish a tax-free transfer, the distribution must be made pursuant to a divorce or separation instrument, defined in Code Section 71(b)(2) as a decree of divorce or separate maintenance or a written instrument incident to such a decree, a written separation agreement, or a decree requiring a spouse to make payments for the support or maintenance of the other spouse. It is important to insure that the property settlement agreement or judgment of divorce clearly specifies that the transfer of IRA funds is required as part of the property settlement and that it is intended to be tax-free under Code Section 408(d)(6). As long as the distribution complies with these requirements, the transfer will be tax free. Nothing further is needed in order to accomplish a tax-free distribution. However, in spite of Code Section 408(d)(6), some financial institutions insist that a qualified domestic relations order (“QDRO”) be issued in order to divide an IRA.
Qualified Domestic Relations Order
By way of background, a domestic relations order (“DRO”) is a judgment, decree, or order (including the approval of a property settlement agreement) that is made pursuant to state domestic relations law (including community property law) and relates to the provision of child support, alimony payments, or marital property rights for the benefit of a spouse, former spouse, child, or other dependent of a participant.
A QDRO is a DRO that creates or recognizes the existence of an alternate payee’s right to receive, or assigns to an alternate payee the right to receive, all or a portion of the benefits payable with respect to a participant under a qualified retirement plan.
Qualified Retirement Plan
A qualified retirement plan is governed by the Employee Retirement Income Security Act of 1974 (“ERISA”) and certain provisions of the Code. In order to be qualified, a plan must adhere to, among other things, specific timing and forms of distributions.
Section 414(p) of the Code, which sets forth the requirements for a QDRO, specifies that only plans subject to Section 401(a)(13) of the Code need a QDRO to distribute benefits to someone other than a plan participant or beneficiary. Code Section 401(a)(13) and ERISA Section 206(d) are the anti-alienation provisions governing qualified plans, which provide that a trust shall not constitute a qualified trust under Section 401(a) of the Code unless it provides that plan benefits may not be assigned or alienated.
An IRA is not a qualified plan, and an IRA is not subject to the requirements of ERISA. So even though an IRA may be considered a marital asset for purposes of equitable distribution, a QDRO is not needed to distribute IRA funds to the spouse. But many financial institutions ignore Code Section 408(d)(6) and take the position that unless a QDRO is in place, the distribution to the spouse will not be made. You can argue with the institution that a QDRO is not required, but it may prove to be a prolonged and expensive proposition. In order to accomplish a distribution, it may be easier to comply with the specific requirements of the financial institution and provide a FAUXDRO (a fake domestic relations order). Since an IRA is an account that generally can be easily valued, a FAUXDRO should be modeled after a QDRO for a defined contribution plan rather than a defined benefit plan.
Some financial institutions have a form FAUXDRO that can be used as a starting point for drafting the order. Whether you use the institution’s document or you have to draft an order for the institution to review and approve, it should include the following information:
- The name, date of birth, and last known address of the IRA holder
- The name, date of birth, and last known address of the spouse
- The IRA identifying information – name on account, account number, institution holding IRA
- The date on which the account will be valued for distribution purposes
- The amount or percentage of the account that will be distributed to the spouse
- A provision as to how the spouse’s portion will be affected by gains and losses from the date of valuation to the date of distribution
- A statement that the distribution is being made pursuant to a property settlement agreement or final judgment of divorce
- A statement that all taxes are to be the responsibility of the spouse
- A date when the distribution will occur
- A provision as to what happens if either the participant or spouse dies before the distribution is made
- A statement as to how an incorrect distribution will be rectified
- A statement that the distribution to the spouse is intended to be tax free pursuant to Code Section 408(d)(6)
Regardless of whether a FAUXDRO is required, it is important to take into account the tax issues when transferring IRA funds to the spouse.
The agreement or judgment should state how the funds will be divided, the date on which the IRA will be valued, and whether gains and losses will be credited/charged to the spouse’s portion during the period between the valuation date and distribution date.
In order to avoid the distribution being immediately taxable, the funds should be transferred directly from the holder’s IRA to the spouse’s IRA. If a direct transfer does not occur, the distribution will be subject to a mandatory 10% federal income tax withholding. If the funds are distributed to the spouse and not rolled over to an IRA or other qualified plan within 60 days of distribution, the total amount is subject to immediate taxation. In addition, any funds received directly by a spouse that has not yet attained age 59 ½ will generally be subject to a 10% early withdrawal tax.
An IRA holder must also be cautious that the IRA funds from a traditional or rollover IRA are not transferred to a spouse before a property settlement agreement is entered into or a final divorce judgment is issued. If they are, the IRA holder, not the recipient spouse, will be taxed on the amount distributed, including any premature distribution tax.
When negotiating the distribution of marital assets, special attention should always be given to any qualified monies, including IRAs. Severe tax consequences could be suffered by either party if the distribution is not done in accordance with Section 408(d)(6) of the Code.
Barbara Murray is a member of Witman Stadtmauer, P.A. in Florham Park where she practices in the areas of employee benefits, ERISA, and residential/commercial real estate. She is a Qualified Mediator Pursuant to Rule 1:40. Ms. Murray is an Executive Vice President of, and pro bono legal adviser to, the New Jersey Camp for Blind Children, Inc. in Rockaway, New Jersey.
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Very nicely written basic primmer on IRA’s and transfer requirements in a divorce setting, plus tax consequences. It would make a good hand out to clients. Thank you.