(Part 7 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)
4. Individual Retirement Account (IRA) Transfers
Except for purposes of calculating the 10% early withdrawal penalty, IRAs are not considered Qualified Plans and therefore there is no requirement that a QDRO be in place to avoid tax on their division in divorce proceedings.
- a) IRA transfers between spouses are tax free if pursuant to a decree of separate maintenance or divorce (or written instrument related thereto).
- b) A QDRO will not protect against early withdrawal penalty from nonqualified retirement plan such as an IRA, SEP or SIMPLE.
- c) Letter Ruling 9344027
Although IRS Letter Rulings are binding only on the parties to which they are addressed, the author is of the opinion that the aforementioned should serve as a cautionary tale to any parties dividing IRAs in a divorce.
The ruling concerns two divorcing taxpayers that had entered into written separation agreement. The taxpayers resided in a community property state.
Taxpayer A had several IRAs which were deemed to be community property. The written separation agreement provided for the equal division of the IRAs.
At the time they requested the ruling, the taxpayers were not legally separated, and there was no divorce or legal separation instrument in place.
The above referenced written separation agreement was a private agreement between the two parties.
The IRS ruled that in order for an IRA transfer between spouses to be tax free under IRC Section 408(d)(6), such transfer must be made pursuant to a divorce or legal separation instrument. In other words, a degree of divorce or separate maintenance, or written instrument incident thereto from a court of competent jurisdiction.
- d) Early Withdrawal Penalty (See Editor’s Note regarding CARES Act – Page 16)
If the receiving spouse takes a distribution from an IRA and he or she is under age 59-1/2, the 10% Early Withdrawal Penalty will apply, assuming one of the exceptions to the penalty is not met. However, the receiving spouse may be able to avoid the 10% early withdrawal penalty by use of the substantially equal periodic payment exception.
- e) Tax Free Transfers of IRAs
The surest way to avoid tax on the transfer of an IRA is to make sure that the transfer complies with the provisions of the IRC Section 408(d)(6) (Michael G. Bunney v. Commissioner, 114 T.C. No.17, April 10, 2000).
There are two requirements that must be met in order for the exception of IRC Section 408(d)(6) to apply:
1–There must be a transfer of the IRA participant’s “interest” in the IRA to his/her spouse or former spouse and;
2–Such transfer must have been made under a Section 71(b)(2) divorce or separation instrument.
The court in Bunney also points out that IRS Publication 590, (since superseded) describes two commonly used methods of transferring an interest in an IRA:
1–changing the name on the IRA to that of the nonparticipant spouse, or
2–directing the trustee of the IRA to transfer the IRA to the trustee of the IRA owned by the nonparticipant spouse.
As of the date of this writing most practitioners still consider the Bunney advice to be sound.
Losses And Other carry Forwards (Discussed In Part 8 of Series on Divorce And Taxes)
Have a question? Contact David Ellis, Ellis & Ellis CPAs.
All Tax Practitioners And Taxpayers Welcome To Contact David With Questions.
(All footnotes will be posted at end of series! This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use. No advisor/client relationship exists.)
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