How to Split an IRA in Divorce

how to split IRA in divorce

Retirement assets such as IRAs, 401(k) plans and pensions typically need to be split in some fashion as part of the divorce financial settlement.

What many people don’t realize is that you need to take specific steps in order to avoid taxes and penalties when dividing retirement accounts.

In this post, I’m going to show you exactly how to split an IRA in divorce so you can steer clear of these hidden landmines.

Let’s get started.

What is an IRA?

An Individual Retirement Account (IRA) is a tax-advantaged investing tool that is used to set aside funds for retirement savings.  There are several kinds of IRAs, each with different possible tax liabilities, depending on a person’s employment status.

If you take money from an IRA prior to age 59 ½, in most cases, you’ll be subject to a 10% withdrawal penalty.

An individual who has earned income can contribute up to $6,000 ($7,000 if 55 or older) in 2020 to an IRA.

Depending on what you earn, you may be able to deduct all or part of your contribution on your tax return.  If you are receiving spousal support that is taxable to you at the federal level, you are considered to have earned income to contribute to an IRA.

The funds deposited into the IRA will grow tax-deferred until Required Minimum Distributions (RMDs) are mandatory.  That takes place when the account owner turns 70 ½, except for a Roth and an inherited IRA.

When the funds are withdrawn, the individual who owns the account pays income tax on the amount taken out.  It is a great strategy to wait until retirement to take distributions since most people are in a lower tax bracket once they stop working.

IRA vs. Roth IRA: What’s the Difference?

The most significant difference between a traditional and Roth IRA is how and when you get a tax break.

With a traditional IRA, your contributions are tax-deductible in the year they are made. The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.

That means contributions to a Roth IRA are not deductible on your tax return, but if you do decide to take a withdrawal once you reach 59 ½, and have held the account for at least five years, you do not have to pay any taxes on the withdrawal.

Also, unlike regular IRAs, Roth IRAs have no required minimum distributions – meaning you never have to take a distribution, ever.

There are income limits on who can contribute to a Roth IRA.  According to IRS rules, if you make too much money, you are not eligible to contribute.

It’s important to note that Roth IRAs may not last forever since the government likes to get paid via taxes, and with Roth’s, they do not receive what they consider their fair share.

Is an IRA Considered Marital Property?

In many cases, yes.

Marital property is any property that a couple acquires during their marriage.  In community property states, marital property is divided equally. In equitable distribution states, the split doesn’t have to be equal necessarily, but it has to be “fair.”

If an IRA was started during the marriage, it is considered marital property even though, by law, the account is only held in one person’s name.

If an IRA was started prior to marriage, but contributions were made during the marriage with joint funds, a portion of the account may be considered marital property.

Inherited IRAs are usually considered separate property.  The caveat here is that those funds should be kept separate.  If they are commingled, they may become marital property.

What is a QDRO?  Do I Need a QDRO to Divide an IRA?

A Qualified Domestic Relations Order (QDRO), it a legal tool used to divide 401(k)s and other employer-sponsored retirement plans.  Executing a QDRO typically costs about $500-$1,000.

Paperwork must be filed with the court and the plan sponsor to distribute a portion of the account to the non-employee spouse.  Each retirement account that is split requires a separate QDRO.

Luckily, with an IRA, you do not need a QDRO.  A transfer does not cost anything.  The final divorce decree is usually is sufficient documentation to divide the accounts.

How do I Divide an IRA in Divorce?

The spouse who will receive a portion of the IRA will need to have an IRA in their own name.  The easiest way to do this is to open an account with the custodian where the IRA being split is held.  A custodian is a company who holds the account. (i.e., Fidelity, Schwab, Vanguard, etc.)

Once the account is open, the final divorce decree and related paperwork is sent to the custodian and tells them how the IRA is supposed to be split.

Assuming all the paperwork is in good order, the funds should be transferred directly into the recipient spouse’s IRA.  That could take anywhere between a couple of days up to a few weeks.

Once the transfer is complete, the recipient spouse can leave the IRA with the custodian it is at or transfer it to the custodian of their choice.

NOTE:  It is possible to transfer an IRA directly from one custodian, where the owner spouse holds their IRA to a different custodian of the recipient spouse’s choice.  That can be done instead of the recipient spouse opening a new account where the IRA is initially held.  In my experience, this can add quite a bit of complexity and delay the transfer as different custodians have different rules surrounding transfers incident to divorce.

What if I am Receiving 100% of my Spouse’s IRA?

If you are awarded 100% of your spouse’s IRA, depending on where the account is held, you may be able to change the name on the account to your name.

However, some custodians still make the recipient spouse open a new account in their name and then proceed with a full direct transfer.

Talk to the custodian where the account is held to find out their rules regarding transfers incident to divorce.

What is the Tax Impact of Dividing IRAs in Divorce?

Any retirement transfer, if done correctly as a direct trustee-to-trustee transfer related to divorce, will be a tax-free transfer assuming the funds stay in the retirement account.

If either spouse takes any distribution, they will pay income tax on the distribution and a 10% penalty if they are under 59 ½.

However, if the owner spouse takes a distribution as part of their divorce settlement, and gives the funds to the recipient spouse, the spouse who took the distribution will be responsible for the taxes and potentially any penalties.

Should I Trade an IRA for other assets?

Deciding what assets are right for you when agreeing to a settlement would depend on your goals once your divorce is final.

Would you prefer retirement assets over a regular investment account or cash?

Age may be a factor depending on how close one spouse or the other is to retirement.

It is crucial to consider the tax implications of the assets you will be receiving.  Remember, a retirement account is pre-tax, and cash has no tax implications, so these two assets are not necessarily equal.

If you’re not sure of how your scenario could play out, seek professional help.  A Certified Divorce Financial Analyst can help you understand the potential tax implications of your settlement and help you understand what your future will look like.

Remember Beneficiary Designations

Once your divorce is final, make sure to update the beneficiary designations on your retirement plans.

If beneficiaries are not clearly defined when the account owner passes away, the account will likely end up in probate, which is a headache for everyone.

FAQs on IRAs and Divorce

Can an IRA be in more than one person’s name?

No.  By law, only one person can be the owner of a retirement plan.  That does not mean the account isn’t marital property.

Can an inherited IRA be transferred tax-free to my spouse in divorce?

Currently, there are no IRS guidelines or rulings that say whether an inherited IRA can be split between spouses.  However, there have been cases where an inherited IRA has been divided due to divorce.

Inherited IRAs cannot be combined with regular IRAs.  The party receiving the inherited IRA will have to take required minimum distributions as a “non-beneficiary spouse,” even if they are under 59 ½.

Can I take a distribution from my spouse’s IRA?

No.  A transfer must be due to divorce to avoid taxes and a penalty. The divorce decree must state the transfer percentage or amount.

If the spouse who owns the account takes a distribution and gives it to the recipient spouse, the spouse whose account it is will be responsible for taxes and a 10% penalty if they are under 59 ½.

Do I pay capital gains taxes when I take a distribution or sell stock in my IRA account?

No.  In retirement accounts, you are not taxed on realized gains when stock is sold.  You will only pay income taxes when cash distributions are taken from the account.

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