Most divorce agreements contain provisions for dividing marital assets. IRA accounts, because of their special tax status, must be treated differently than other types of financial assets. The following article attempts to explain how division of IRAs may be handled in the event of a divorce.
I. Statutory Framework
Section 408(a) of the Code provides, in pertinent part, that for purposes of section 408, the term “individual retirement account” means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries, but only if the written governing instrument creating the trust meets certain requirements specified under section 408.
Section 408(d) of the Code establishes the general requirements for the tax treatment of distributions from IRAs.
Section 408(d)(1) of the Code states that, except as otherwise provided in this subsection, any amount paid or distributed out of an IRA shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72 of the Code.
Section 408(d)(6) of the Code states that the transfer of an individual’s interest in an IRA to his or her spouse or former spouse under a divorce or separation instrument described in subparagraph (A) of section 71(b)(2) is not to be considered a taxable transfer made by such individual notwithstanding any other provision of this subtitle, and such interest at the time of the transfer is to be treated as an IRA of such spouse and not of such individual. Thereafter such IRA for purposes of this subtitle is to be treated as maintained for the benefit of such spouse.
Section 71(b)(2)(A) of the Code states that a divorce or separation instrument is a decree of divorce or separate maintenance or a written instrument incident to such a decree.
Section 1.408-4(g)(1) of the Income Tax Regulations states that the transfer of an individual’s interest, in whole or in part, in an IRA to his or her former spouse under a valid divorce decree or a written instrument incident to such divorce shall not be considered to be a distribution from an IRA to such individual or the former spouse; nor shall it be considered a taxable transfer by such individual to his former spouse notwithstanding any other provision of Subtitle A of the Code.
Section 1.408-4(g)(2) of the Regulations provides that the interest described in this paragraph (g) which is transferred to the former spouse shall be treated as an IRA of such former spouse.
Section 408(d)(6) of the Code specifies that IRA transfers incident to a divorce are not taxable at the time of the transfer. Section 408(d)(1) provides that, except as otherwise provided in section 408(d), any amount distributed out of an IRA shall be included in gross income by the distributee in the manner provided under Section 72 of the Code. In order to apply section 72 to amounts distributed from an IRA, the IRA must be taxable under section 408(d)(1). Accordingly, amounts transferred pursuant to a divorce decree as specified in section 408(d)(6) are not taxable under section 408(d)(1).
II. Is a QDRO Necessary to Divide an IRA?
Unlike IRAs, qualified retirement plans such as pension, profit sharing and 401(k) plans have to be concerned with both tax issues governed by the Internal Revenue Code (“Code”) and labor issues governed by the Employee Retirement Income Security Act of 1974 (“ERISA”).
One of the conditions imposed on qualified retirement plans in Code Section 401(a)(13) and Section 206(d)(1) of ERISA is that a participant’s benefits may not be alienated (i.e., paid to anyone other than the participant) during his or her lifetime. A QDRO, which allows some or all of a participant’s benefits to be paid to an “alternate payee” such as a spouse or former spouse, provides the only exception to this anti-alienation requirement. Without a QDRO, a distribution such as this would violate the anti-alienation requirement and disqualify the plan.
IRAs are not subject to the anti-alienation requirement. Thus, QDROs are not needed to divide IRAs, even if the IRA is a rollover IRA from a qualified retirement plan.
III. Avoiding Undesirable Tax Consequences
Even though IRAs are not subject to the qualified plan requirements of the Code and Title I of ERISA, they are tax deferred accounts. As such, they are governed by Code Sections 72 and 408. These sections provide that a distribution from an IRA is included in the IRA owner’s gross income without regard to community property interests. When an IRA is community property, how can the spouse receive his or her one-half interest without causing adverse tax consequences to the IRA owner?
Code Section 408(d)(6) provides a method for dividing an IRA upon divorce. This provision permits the division of an IRA without immediate tax consequences to either the IRA owner or the spouse if certain requirements are met. Once divided, Code Section 408(d)(6) treats the portion of the IRA transferred to the spouse as the spouse’s own IRA, thereby shifting the tax liability for future withdrawals to the spouse.
Code Section 1041 provides that no gain or loss shall be recognized on a transfer of property from an individual to, or in trust for the benefit of, a spouse. Nevertheless, a transfer from one spouse’s IRA directly to the other spouse’s IRA does not enjoy the non-recognition treatment of Code Section 1041. IRA transfers are governed by Code Section 408(d)(6). The IRS has privately ruled that under general principles of statutory construction, a specific provision of the Code controls over a general provision. Furthermore, when Code Section 1041 was added to the Code, there was no indication of legislative intent to override Code Section 408(d)(6). See PLR 9422060. Thus, absent compliance with Code Section 408(d)(6), a transfer from one spouse’s IRA to the other spouse’s IRA would be treated as a distribution to the owner of the transferring IRA.
The requirements of Code Section 408(d)(6) are simple, but very specific. First, there must be a decree of divorce, a decree of separate maintenance, or a written instrument incident to such a decree. Second, there must be a transfer of an interest in an IRA to the spouse or former spouse.
What is a decree of divorce, decree of separate maintenance or written instrument incident to such a decree? A judgment of dissolution, even as to status only, would be a decree of divorce. An order dividing the IRA could be entered as part of such a judgment or at any time after entry of judgment.
The more troublesome question is whether an IRA can be divided before entry of a judgment of dissolution. In other words, what does “decree of separate maintenance” mean? We are unaware of any tax authority on this question. However, the Internal Revenue Service has addressed a related question in a private letter ruling.
Private Letter Ruling 9344027: Husband had received substantial qualified plan benefits upon retirement and had rolled them over to several IRAs. He and his wife separated, and she moved out of the country. They entered into a “separation agreement” in which they agreed to divide the IRAs equally. They sought a ruling from the IRS that the transfer of one-half of each of husband’s IRAs to an IRA in wife’s name would not be taxable pursuant to Code Section 408(d)(6).
The IRS ruled that the transfers to wife’s IRA from husband’s IRAs would be taxable to husband. In reaching this conclusion, the IRS found that the taxpayers’ written separation agreement was not “a written instrument incident to a decree of divorce or separate maintenance” as required by Code Section 408(d)(6).
Although a private letter ruling can be relied upon only by the taxpayer who requested it, the PLR does shed light on the IRS’s analysis of the question raised. In the PLR, the IRS identified additional factual representations that the taxpayers might have made in their ruling request that could have changed the IRS’s conclusion.
The taxpayers had not asserted that they were “legally separated.”
The taxpayers had not asserted that they intended to present their agreement to the court so the court could enter a decree with respect to it. According to the PLR, permanently living apart, with no intention of divorcing, did not constitute being legally separated.
The prudent answer in California would be that a decree of legal separation is necessary to constitute a “decree of separate maintenance.” It is questionable whether anything less than a judgment of legal separation would be considered a decree of separate maintenance.
What is a transfer of an interest in an IRA to the spouse or former spouse? The owner’s interest in the IRA must be transferred to an IRA in the name of the spouse or former spouse. This does not mean that there will be a distribution outright to the spouse or former spouse. On the contrary, the recipient of the transfer from the IRA must also be an IRA, albeit the spouse’s or former spouse’s IRA. Thereafter, for all purposes, the spouse or former spouse is the owner of the recipient IRA. Once the transfer is complete, the spouse is free to withdraw from the recipient IRA, subject to income taxation as well as the 10% penalty if the spouse is younger than age 59 1/2.
Is the community property interest of a former spouse recognizable for federal income tax purposes? The answer is no according to the United States Tax Court in Bunney v. Commissioner, 114 T.C. 259 (2000). In that case, the IRA owner withdrew funds from his IRA, paid his former spouse’s community interest to her, and included only the balance that he retained in his gross income. His tax position was that his former spouse was responsible for the income tax on her community interest in the IRA distribution.
The Tax Court disagreed and held that since the IRA was established in petitioner’s name and was the sole distributee, his wife should not be treated as a distributee despite her community property interest in the IRA. Applying community property laws would make it impossible to comply with the IRA requirements and would prevent symmetry in treatment of IRAs as between community property and non-community property states.
The major disaster case is Rodini v. Commissioner, 105 T.C. 29 (1995). In that case, the employee was a member of his employer’s profit-sharing plan. When the plan terminated, he was eligible to receive a distribution of $307,000. Whether or not he knew at that time that he would soon be divorced and that his spouse would be awarded a community property interest in the plan distribution, he delivered his distribution check from the plan to his spouse and she rolled over most of the proceeds to an IRA in her name.
The IRS challenged the rollover because the spouse was not an employee of the company that sponsored the plan or a distributee. Therefore, her IRA was not an eligible retirement plan to receive the IRA rollover. The Tax Court concluded that the IRA receiving a rollover from a qualified plan must be established for the benefit of the individual who received the distribution. Thus, the rollover was disqualified. The $307,000 distribution was included in the employee’s income in the year it was distributed from the plan. Since he was younger than age 59 1/2, the additional 10% tax on premature distributions applied. The spouse was also subject to an excise tax of 6% on the $219,000 excess contribution to her IRA.
There were two alternatives available to the parties’ to properly handle this division. First, if the parties marital dissolution action was pending when the employee received the plan distribution, they could have obtained a QDRO assigning all or any portion of the distribution to the spouse. Then the spouse could have received her share and rolled it over to her own IRA. The advantage of this approach is that the portion not rolled over would have been exempt from the 10% additional tax on premature distributions on account of the QDRO exception.
Second, the employee could have rolled over the distribution to an IRA in his name. Then, the parties could have included in their Judgment of Dissolution a provision whereby some or all of the employee’s IRA would be transferred to the spouse. Their Judgment of Dissolution would then have included a provision whereby his IRA would be divided and the spouse’s share transferred to her IRA. The disadvantage of this approach is that any funds withdrawn from either IRA would be subject to the 10% tax on premature distribution because the QDRO exception would not apply.
IV. Mechanics of the Transfer
Once the proper court order has been entered, the IRA can be divided in accordance with Code Section 408(d)(6). This can be accomplished by transferring a fixed dollar amount or percentage of the owner’s IRA to the spouse’s IRA. Alternatively, the IRA owner can set up a separate IRA containing the amount to be transferred and then assign that entire separate IRA to the spouse by merely changing the name on the account. In either case, after the transfer, the spouse is the owner of the recipient IRA.
Securities can be liquidated or transferred in kind, and expenses can be shared or borne by one of the parties. The court order should specify these terms to avoid delays and the need for postjudgment negotiation.
Even though an IRA division does not require a QDRO, sometimes it is advisable to prepare a separate court order to divide an IRA. This is because the IRA custodian or trustee, whether a bank, trust company, brokerage firm or insurance company, will usually request a copy of the court order. If the provisions dividing the IRA are contained in the judgment, issues of privacy and confidentiality arise. A separate order can be entered and sent to the IRA custodian along with a notice of entry of judgment to effect an IRA division without having to forward the entire judgment to the IRA custodian.
V. Special Rule for SEP IRAs
There is a special type of IRA known as a SEP IRA. A SEP IRA is established by an employer for the benefit of its employees. The Department of Labor takes the position in its regulations that a SEP IRA for an employee other than the owner is an employee pension benefit plan under ERISA. As discussed above, Section 206(d) of ERISA contains the anti-alienation requirement and the QDRO exception. Consequently, it appears that a QDRO would be needed to divide a SEP IRA.
There is scant authority one way or the other on this issue. In LaChapelle v. Fechtor, Detwiler & Co., 901 F. Supp. 22 (D. Me. 1995), a federal district court ruled that a SEP IRA is not a pension plan within the meaning of ERISA, citing the Department of Labor’s refusal to answer this question when it had the opportunity to do so in an opinion letter. Nevertheless, the cautious approach would be to prepare a separate order that meets the requirements of a QDRO when dividing a SEP IRA that covers non-owner employees.
VI. Litigation Issues
Standing to Sue
A divorced spouse did not have standing under a decree where the underlying plan was a SEP IRA, and thus not an ERISA pension or welfare benefit plan. Although an alternate payee under a QDRO is considered a beneficiary under ERISA Section 206, this provision is in Part 2 (of Subtitle B of Title I) of ERISA, which covers only pension plans and not IRAs governed by Code Section 408 IRAs. Also, even though the Code treats an IRA transfer incident to a divorce as maintained for the benefit of the recipient spouse, this provision is directed at tax treatment and has no impact on ERISA standing.
VII. Distributions from IRAs Pursuant to Section 72(t)
Series of Substantially Equal Payments
The additional tax on early withdrawals from qualified plans and IRAs found in IRC Section 72(t) does not apply to distributions that are part of a series of substantially equal periodic payments, made not less frequently than annually, for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and his designated beneficiary. In the case of a series of payments from a qualified plan, as opposed to an IRA, the series of payments must begin after the employee separates from service.
Modifications
If the series of payments is modified, other than because of death or disability, before the close of the five-year period beginning with the date of the first payment and after the employee attains age 59 1/2 or before the employee attains age 59 1/2, the tax for the first taxable year in which the modification occurs is increased by an amount equal to the tax which, but for the exemption, would have been imposed, plus interest, for the period beginning with the taxable year in which the distribution would have been includible in gross income and ending with the taxable year in which the modification occurs.
Safe Harbor Methods
According to Internal Revenue Notice 89-25, payments are considered to be substantially equal periodic payments if they are made according to one of the methods set forth below. However, these are not the only permissible methods.
The annual payment is determined using a method that would be acceptable for purposes of calculating the minimum distribution required under IRC Section 401(a)(9);
The amount to be distributed annually is determined by amortizing the taxpayer’s account balance over a number of years equal to the life expectancy of the account owner or the joint life and last survivor expectancy of the account owner and beneficiary (with life expectancies determined under Prop. Reg. Section l.401(a)(9)), an interest rate that does not exceed a reasonable interest rate on the date payments begin; and
The amount to be distributed annually is determined by dividing the taxpayer’s account balance by an annuity factor (the present value of an annuity of $1 per year beginning at the taxpayer’s age attained in the first distribution year and continuing for the life of the taxpayer), with this annuity factor derived using a reasonable mortality table and using an interest rate that does not exceed a reasonable interest rate on the date payments begin.
VIII. IRA Beneficiary Designations and Divorce
The proceeds of an IRA will be payable upon the death of the IRA owner in accordance with the terms of the IRA governing instrument. In most cases, the IRA governing instrument will state that in this situation, the IRA proceeds will be paid to the primary beneficiary designated by the IRA owner, if the primary beneficiary survives the IRA owner and, if not, then the contingent beneficiary receives the IRA proceeds.
Is a beneficiary designation valid if the IRA owner designates his or her spouse as primary beneficiary, then they divorce but the IRA owner never changes the beneficiary designation?
In the case of a qualified plan, where this issue can also arise, there are questions of ERISA preemption that must first be resolved before the substantive question is addressed. There is a conflict among the circuits as to how the proceeds of a qualified plan are paid when a participant dies with a former spouse still named as primary beneficiary.
In the case of an IRA, which is not governed by ERISA, state law will determine whether the divorce decree divests the former spouse of the right to receive the IRA proceeds after the owner’s death.
It may be possible to draft an IRA beneficiary designation so that it automatically becomes null and void upon divorce. The governing IRA instrument should be reviewed and any special language in the beneficiary designation should be reviewed by the IRA custodian, who should be asked to acknowledge the designation in writing.
Information contained in this article was partially derived from National Legal Research Group, Inc.
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