Provided By Lauren Silvey and Steven J. Riddle, Somerset CPAs
Divorce continues to occur frequently in today's society. As a result, many are left with the question “what happens next?” One of the contentious issues in a divorce is the division of assets and the financial and tax ramifications that entails. Who gets what, how it is split and the tax consequences are all critical considerations. Often, a significant marital asset is the retirement plan, be it a traditional or Roth IRA, a qualified retirement plan [i.e. 401(k)], profit sharing plan or other qualified plan. The division of this financial asset can cause complications.
A Qualified Domestic Relations Order (QDRO) creates the existence of an alternate payee’s rights to receive benefits from the participant’s qualified retirement plan. A transfer pursuant to a QDRO does not create any tax liability to the distributing spouse and as long as the recipient spouse rolls the assets into his/her own qualified plan. A QDRO does not apply to either a traditional or a Roth IRA distribution incident to divorce. A traditional or Roth IRA that is transferred incident to divorce allows the recipient to take legal ownership of the assets and assume the tax consequences for any distributions made after the transfer.
Generally, if the retirement accounts are split and the recipient spouse reinvests their portion of the retirement assets into a new retirement account within a designated time frame, no income tax will be assessed.
However, if the receiving spouse is under the age of 59.5 years old and decides not to reinvest the retirement assets into an IRA or other qualified plan, there will be an early withdrawal penalty of 10% and income tax due on the amount withdrawn.
There are exceptions that allow the waiver of the 10% penalty but not the income tax. The recipient spouse will not be assessed the penalty if the funds are used for medical expenses (determined without regard to whether the taxpayer has itemized deductions for such taxable year) to the extent the medical expenses exceed 10% of his/her Adjusted Gross Income. Another exception to the penalty applies to IRAs if the distributions were for higher education expenses for the recipient or the recipient’s child or grandchild.
In addition, distributions from either an IRA or a qualified plan that are part of a series of substantially equal periodic payments made over the life expectancy of the recipient qualify for exception from the 10% early withdrawal penalty. Other exceptions from the early withdrawal penalty can be found in under the Internal Revenue Code Section 72(t). Please note that different exceptions apply to distributions from IRAs as compared to distributions from qualified retirement plans.
This post was written by Lauren Silvey and Steven J. Riddle of Somerset CPAs. If you would like to submit content or write an article for the Family Law Section page, please email Mary Kay Price at email@example.com.