Handling Divorce Assets in Qualified Retirement Plans and IRAs: There Is a Difference
By Jonathan Yahn, JD, CPC
Suppose a client asks you whether an ex-spouse’s retirement assets are taxed or penalized when your client receives them. Even without knowing all of the details in this potentially loaded question, you can safely respond “it depends.” Of course, your client may not appreciate that response. So let’s discuss some of the differences between how various retirement assets are treated in divorce—and equip you to respond more helpfully.
401(k) and Other Qualified Plan Assets
Qualified retirement plan (QRP) assets can be distributed to a former spouse through a document known as a QDRO (“QUAD-roe”), which stands for qualified domestic relations order. A QDRO is a domestic relations order that is “qualified” by a plan administrator. This simply means that the divorce decree (or separation order) contains all of the necessary information to properly process the distribution of assets. If the administrator determines that the domestic relations order is qualified, the assets may be paid to the recipient, known as the “alternate payee.”
Assuming that the plan permits current payment (a QDRO is a very common, but not universal, distribution trigger), the alternate payee generally has two options: roll over the assets to another eligible plan or take the assets (or part of the assets) as a generally taxable distribution. One important rule to remember: alternate payees can receive these assets directly from the plan without the pre-59½ 10 percent penalty tax that normally applies to taxable distributions. A rollover to an IRA, however, negates this exception.
Example: At age 47, Frieda receives $100,000 from her ex-spouse’s 401(k) plan. She rolls over the entire amount to her IRA. Later, when she needs some money, she decides to tap into her IRA. Unfortunately, not only will she pay income tax on the IRA distribution but, unless she has one of the other possible exceptions, she’ll be subject to the early distribution penalty tax. Had she taken the money directly from the 401(k) plan—rather than from her IRA—she could have avoided this extra tax.
IRA Assets
IRA assets subject to divorce proceedings are paid in a completely different manner. The Internal Revenue Code allows for these assets to be paid through a “transfer incident to divorce.” Corresponding regulations require only a “valid divorce decree” (or other written instrument, such as a court-approved property disposition) to transfer IRA assets.
Required Documentation
Unlike QRP assets—which, to be moved, requires a QDRO—IRA assets can more easily be transferred to the former spouse. While a QDRO must contain detailed information about the amount and timing of the payments (and about the plan itself), a divorce decree addressing IRA assets can be less specific. The financial organization just needs enough information to properly transfer the assets to the appropriate party.
Example: Secure Financial receives a request to transfer one-half of a client’s IRA into the IRA of the client’s former spouse. Although the certified copy of the divorce decree does not contain the exact amount to be paid or the account number, it is sufficiently clear to permit Secure Financial to process the transfer. (Each financial organization should create its own policy for what information and authorization is needed to process transfers incident to divorce.)
A divorce decree could address the payment of multiple accounts to a former spouse. In other words, one document could authorize an IRA transfer and also contain information related to a 401(k) or other plan. Conversely, it’s quite common for attorneys to create a separate document to address the accounts of each plan that requires a QDRO for a distribution. This makes it easier to send plan administrators only the information that they need to process that plan’s assets—without revealing their clients’ other assets.
Transfers Incident to Divorce
Although these transfers are common and usually straightforward, you may want to keep certain details in mind.
The IRA assets become the recipient’s own IRA. Former spouses who receive assets through a transfer incident to divorce must establish an IRA if they don’t already have one. Once the assets are moved to the recipient’s IRA, any distributions are subject to the tax (and penalty) that normally applies. Unlike QRP assets that are subject to the QDRO rules, a distribution after a transfer incident to divorce is generally subject to a 10 percent early distribution penalty tax if the recipient is under age 59½.
The transfer is nonreportable. In this type of transaction, assets are simply journaled or transferred into the recipient’s IRA. Moving the funds to a former spouse is not considered a distribution from the sending account or a contribution to the receiving account; thus, no IRS reporting is required.
Consider how best to handle divorce transfers. This can be a bit tricky. On the one hand, a valid divorce decree requires you to transfer certain assets. On the other hand, you want to treat your clients with care.
Example: Corey presents you with a valid dissolution decree, which grants him 100% of your client Beth’s IRA. After filling out the required distribution forms, Corey is on his way with the IRA assets. A month later, your client, Beth, sees the zero balance on her account statement and phones you in a panic, wondering what happened to her IRA. Was there a better way to handle the transfer from Beth’s IRA?
Even if your client ultimately has to relinquish all or a portion of her IRA to a former spouse, you may gain some favor with her by clearly communicating your role in the process. For example, along with your other procedures that address transfers incident to divorce, you may include a process to generate a letter to your client, describing your intention to distribute assets based on receiving the divorce decree. Although reaching out to your clients may not change the final result, at least they may appreciate that your organization is extending the courtesy of keeping them in the loop.
Avoid “Separation Anxiety”
Transferring IRA assets upon divorce or legal separation shouldn’t cause disruption in your operations. For many divorcing couples, retirement assets make up one of the largest portions of their net worth. So dividing these assets is quite common. Knowing about the differences in paying out IRA and qualified plan assets can help you create a process to address these routine transactions, saving you time and effort. And effectively handling transfers incident to divorce can make your clients’ lives a little less stressful.
