“Happily ever after?” Marriage statistics, unfortunately, say “Not always.”
In fact, some 40% to 50% of marriages end in divorce (per Divorce.com, Apr. 12, 2023). And as for second and third marriages? Those rates are even higher — on the order of 60% and 73%, respectively. “Money” meanwhile is the most common reason for divorce (per SurviveDivorce.com, Aug. 2, 2022).
Just as the motives for ending marriages are complex, so too are the financial aspects of divorce. Consider the division or transfer of qualified plan benefits, individual retirement accounts and nonqualified annuities. Untangling ownership of such assets can be especially complicated. The results often carry unintended tax consequences and sometimes turn an equitable distribution into one not so equitable.
Different Internal Revenue Code sections apply in the case of each of the following:
• Section 414(p) for qualified plan benefits.
• Section 408(d)(6) for IRAs.
• Section 1041 for nonqualified annuities.
Straying from the correct applicable tax rules could result in current taxation and, possibly, taxation of the wrong party.
Qualified Plan Benefits
Qualified plans under IRC Section 401 (e.g., defined benefit plans, money purchase pension plans, 401(k) plans) are subject to the anti-alienation provisions of the Employee Retirement Income Security Act of 1974 and the IRC. These provisions generally prohibit payment to a person other than the participant. A qualified domestic relations order is one of a handful of exceptions to the provisions. A QDRO is a judgment, decree or order that awards all or a portion of a participant’s benefits to an alternate payee and that meets all the requirements under IRC Section 414(p).
A participant can transfer all or part of their qualified retirement plan benefits to a former spouse without being liable for income taxes on the transfer if the transfer is made pursuant to a QDRO.
If the alternate payee who is the participant’s spouse or former spouse receives a distribution by reason of a QDRO, the rollover rules apply to the alternate payee as if the alternate payee were the participant.
Thus, the former spouse/alternate payee can avoid the requirement of including the distribution in income to the extent any portion of an eligible rollover distribution is rolled over or transferred to an IRA or other eligible retirement plan within 60 days.
In the case of spouses who are younger than 59½, it is important to keep in mind that the QDRO exception to the imposition of the 10% early withdrawal penalty applies only to distributions from a qualified plan. Once the distribution is rolled over to their own IRA, the exception no longer applies.
IRC Section 408(d)(6) provides that the transfer of an individual’s interest in an IRA to their former spouse under a decree of divorce (or separate maintenance or a written instrument incident to such decree) is not considered a taxable transfer, and such interest is to be treated thereafter as the IRA of the recipient’s former spouse.
Even though there are only two requirements — (1) a decree/written instrument and (2) a transfer of an IRA interest — there have been many instances in which the IRA owner has been forced to include the distribution in their taxable income and, if applicable, pay the 10% early distribution penalty.
The catch is that the transfer must be to an IRA of the former spouse. Cashing out an IRA and endorsing the distribution check over to the former spouse has been held not to be a transfer of the IRA owner’s “interest.”1 Even if the former spouse wants to receive cash, it is essential that the IRA owner transfer the amount required in the divorce decree or separate written instrument to an IRA in the name of the former spouse and have the former spouse take the distribution from their own IRA.
Although dividing an IRA does not require a separate domestic relations order, it may be beneficial to have a separate order drafted and approved. Otherwise, the IRA owner will need to provide a copy of the entire judgment to their financial institution. A separate court order will allow the IRA owner to keep other aspects of the divorce agreement confidential.
There appears to be a difference of opinion regarding what is required to divide a SEP IRA — is it subject to ERISA and a QDRO or not? Are non-owner employees covered under the SEP IRA? A best practice may be to prepare a separate DRO that meets the requirements of a QDRO just in case.
IRC Section 1041 provides that no gain or loss will be recognized on a transfer of property from an individual to a spouse or a former spouse during marriage or incident to divorce. Thus, the owner of the nonqualified annuity who makes the transfer or gift does not recognize income upon the transfer, and the transferee’s investment in the contract is the same as the transferor’s investment in the contract.
Transfers made within one year of divorce are presumed to be made incident to divorce. Such transfers do not have to be required by the divorce or separation agreement. Transfers made within six years after the date the marriage ends are considered to be related to the end of the marriage if required by a divorce or separation agreement.
Nontax Considerations for Annuities
Dividing an annuity between spouses can have nontax consequences as well. A change in ownership of an annuity contract may result in the termination of optional benefits and riders. Any distributions from an annuity contract, even those mandated by a court, can affect the account value, benefit base and lifetime income. It is important to discuss possible contract- or carrier-specific consequences with either a financial professional or the insurance company.
In the case of annuities with strong guarantees and valuable riders, it may make sense for the parties to look at other assets that might be split. It may be less costly and a more effective financial solution to try to duplicate the benefit for the other spouse with an alternate asset rather than lose the benefit for both spouses.
Consequential Decisions Call for Caution
Retirement assets typically are some of the largest assets owned by clients. Depending on the parties involved, dividing those assets in divorce can be difficult for both personal and financial reasons. Financial professionals must work with their client’s divorce attorney to ensure all parties understand and consider the short- and long-term financial and tax implications of decisions made during such trying times.
The information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) addressed by this material. This material is being provided for informational purposes only. W&S Financial Group Distributors does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. Consult an attorney or tax advisor regarding your specific legal or tax situation.
1 Stephen R. Jones v. Commissioner, TC Memo 2000-219.