In a divorce or legal separation, IRAs are divided using a process known as transfer incident to divorce, while 403(b) and qualified plans such as 401(k)s are split under a qualified domestic relations order (QDRO). Whether you are giving up retirement funds or receiving them, you need to understand the rules that govern asset division in a divorce.

When you define and allocate retirement-plan assets in a divorce correctly, you can avoid costs in taxes and more.

Key Takeaways

  • In a divorce, IRA divisions are classified as transfer incidents.
  • During a divorce, you will not be expected to pay taxes on the immediate division of retirement accounts if you file them correctly with the courts.
  • QDROs (qualified domestic relations orders) manage the division of retirement accounts that are not IRAs.
  • Make sure to update beneficiaries during the divorce.

Dividing an IRA: Transfer Incident

If you specified that your IRA division is to be treated as a transfer incident to divorce in your agreement, no tax will be assessed on the separation transaction. The movement of funds may be classified as either a transfer or a rollover by the IRA custodian, depending on the circumstances of the division and how the decree is worded.

The recipient will take legal ownership of the assets when the transfer is complete. Then, they will assume sole and total responsibility for the tax consequences of any future transactions or distributions.

Example of How an IRA Can Be Split

So, for example, if you are going to give half of your IRA to your soon-to-be ex-spouse in the form of a properly labeled transfer incident, they will have to pay the tax on any distributions they take out of the account after they receive the funds. You will not owe tax on the assets that were sent to them because you followed the IRS rules for transfer incidents.

If, however, you failed to adequately label your division as such, you will owe both tax and an early withdrawal penalty (if applicable) on the entire amount that your ex-spouse received. To avoid this, be sure to clearly list both the division percentage breakdown and the dollar amount of IRA assets transferred, as well as all the sending and receiving account numbers for all of the IRAs involved in the transfer.

The instructions that you provide need to satisfy both the sending and receiving IRA custodians, as well as the judge and state laws. If the division agreement is not approved by the courts, the IRS will require you to file an amended tax return that reports the entire amount you sent to your ex as ordinary income.

In addition, the balance your ex-spouse received cannot be put into an IRA because it was not an eligible transfer. This means your former spouse will lose the benefit of tax deferral on that money and may ask to you to compensate them for that loss.

It can be beneficial and well worth the money to hire a financial professional to assist in the splitting of retirement or any other type of financial account. Certified Divorce Financial Analysts (CDFAs) specialize in the division of assets when spouses divorce.

Tracking the Basis of IRA Assets

Some qualified transfer incidents are made from an IRA that has been partially funded with non-deductible contributions.

If this is the case with you, both you and your ex will need to know the dollar amount of non-deductible contributions. You will need to file tax Form 8606 with the IRS in order to correctly calculate and report the allocation of the non-deductible amounts.

Dividing a Qualified Plan: QDRO

Divorce is one of the few exceptions to the protections from seizure or attachment by creditors or lawsuits that federal law accords to qualified retirement plans.

Divorce and separation decrees allow the attachment of qualified-plan assets by the ex-spouse of the plan account owner if the spouse uses a qualified domestic relations order (QRDO). A QDRO is used to divide qualified retirement plan assets between the owner and their current or ex-spouse or children or other dependents.

QDROs resemble transfer incidents to divorce in that they are tax-free transactions, as long as they have been reported correctly to the courts and the IRA custodians. The receiving spouse may roll QDRO assets into their own qualified plan or into a traditional IRA or Roth IRA (in which case the transfer will be taxed as a conversion but not penalized).

Any transfer from a qualified plan in a divorce settlement that is not deemed a QDRO by the IRS would be subject to tax and penalty.

A QDRO must comply with the Employee Retirement Income Security Act (ERISA). ERISA provides a regulatory framework for employer-sponsored retirement plans to provide protections for beneficiaries and participants. IRAs are not subject to ERISA.

Remember to Update Beneficiaries

After you send or receive your IRA or qualified-plan assets, be sure to add or update your beneficiaries. Your ex-spouse will probably not be among your beneficiaries, unless your divorce decree requires it. (Also, update the beneficiaries on all your other financial assets, including for annuities and life insurance.)

If you are going to get remarried and/or your children will be your primary beneficiaries, it may be prudent to create a revocable living trust and make the trust the primary or secondary beneficiary of your plan or account. An estate-planning attorney can help you accomplish this and ensure that your retirement assets will be dispersed according to your wishes.

How Do You Divide an IRA in a Divorce?

If you are in the process of getting divorced, IRA assets can be divided by what is called a “transfer incident to divorce.” The division must be clearly categorized as a transfer incident in the divorce agreement submitted to a judge or mediator. Not doing so can cause complications, such as tax consequences.

How Are 401(k) Accounts Handled in a Divorce?

Assets in a 401(k) account must be divided under a qualified domestic relations order (QDRO). A QRDO is a legal document commonly used in divorce agreements to divide retirement plan assets. QRDOs can only be used for retirement plans covered by Employee Retirement Income Security Act (ERISA).

How Are IRA Assets Paid in a Divorce?

IRA assets that are divided in a divorce can be paid out in a number of ways. The funds can be transferred to another retirement account, received via a lump sum, or paid in installments. Typically a divorce agreement would spell out how the funds are received.

The Bottom Line

The type of retirement plan—that is, whether it is an IRA or a qualified plan—determines the rules that apply to how retirement plan assets are divided in a divorce. You and your spouse need to clearly delineate the category into which each of your retirement assets falls when you submit your information to the judge or mediator so they are listed correctly in the divorce or separation agreement. Failing to do this can result in complications.

If the courts and the IRA and/or qualified-plan custodians recognize your divisions as transfers incident to divorce or QDROs, there will be no tax consequences for you or your ex. Paying attention to detail in properly handling the division of retirement assets can make the divorce process less complex and less expensive, especially if large sums of money are involved.

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