Dividing IRAs in Divorce: Why a QDRO is not necessary to assign IRA benefits to an ex‐spouse
Contrary to popular belief, a Qualified Domestic Relations Order (“QDRO”) is not necessary to divide every type of retirement benefit. The prime example is an Individual Retirement Account (“IRA”). An IRA is not a qualified retirement plan under the Internal Revenue Code and an IRA is not regulated by the Employee Retirement Income Security Act (“ERISA”). Therefore, ERISA regulations and Internal Revenue Code section 72(t) which otherwise govern QDROs do not pertain to IRAs.
If a financial institution representative informs you that a “court order” or “QDRO” is required to divide an IRA, then your client should provide the financial institution with a copy of the Judgment and MSA which will suffice as the court order. A letter of instruction or other forms will still be necessary, but as far as providing a court order, the Judgment and MSA will satisfy the requirement of a court order.
The good news for family law attorneys is that the process for dividing an IRA is more simplified than having a QDRO prepared. However, there are two aspects unique to IRAs that should be kept in mind:
Early withdrawal penalties apply.
Unlike the transfer of plan benefits with a QDRO, there is no exception in the Internal Revenue Code that permits a spouse to avoid the early withdrawal penalty of 10% (federal) and 2.5% (California) when receiving a distribution of IRA benefits prior to reaching age 59½. In other words, if an IRA holder desires to cash out their benefits prior to reaching age 59 ½, there will be a 12.5% penalty and the distribution amount will be taxed at ordinary income tax rates. For clarity, it should be noted that if the IRA benefits are merely being “rolled over” using a “trustee-to-trustee transfer” from one spouse’s IRA to the other spouse’s IRA, then there is no tax consequence on that transfer and the benefits are held in the receiving spouse’s IRA as pre-tax benefits.
In contrast, the Internal Revenue Code provides under section 79(t)(2)(C) that a QDRO qualifies for an exception to the early withdrawal penalty. Therefore, if the parties are planning to take any distributions of retirement benefits prior to age 59½, it may be preferable to do an equalizing assignment with a QDRO rather than equalizing benefits with an IRA.
A tax statement is recommended.
A signed “letter of instruction” with tax language is still recommended when an IRA is divided. Although a QDRO is not necessary, it is still important to document the IRA transfer in the event that the IRS or Franchise Tax Board conducts and audit of the IRA transfer.
The typical tax statement will contain something similar to the following:
IRA Holder is the former spouse of Recipient. Both IRA Holder and Recipient acknowledge that this assignment is incident to divorce within the meaning of Internal Revenue Code section 1041. This assignment is related to the cessation of the marriage because this assignment is required by the Marital Settlement Agreement entered into between the IRA Holder and the Recipient. After the transfer, the Recipient shall be solely responsible for all income taxes or
other tax consequences, if any, associated with the subsequent distribution of the assets to Recipient.
For reference, the above language is intended to comply with the Internal Revenue Code section that provides for the tax free transfer of IRAs between spouses pursuant to divorce which is section 408(d)(6). The meat of Internal Revenue Code section 408(d)(6) is as follows:
(6) Transfer of account incident to divorce The transfer of an individual’s interest in an individual retirement account or an individual retirement annuity to his 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 individual retirement account of such spouse, and not of such individual. Thereafter such account or annuity for purposes of this subtitle is to be treated as maintained for the benefit of such spouse.
What is the end result? The division of an IRA does not require a QDRO; however, a tax statement should accompany the IRA transfer documentation to document compliance with IRC section 408(d)(6) if the IRS or Franchise Tax Board conducts an audit.