IRA in Divorce
Divorce is expensive. When a couple makes the decision to divorce, they expect to have to redistribute their shared assets: the family home and other real estate, vehicles, boats, and other valuable property, as well as money in shared accounts. But what about retirement assets like pensions and IRAs?
You will likely have to give a portion of any IRA you own to your spouse through transfer–unless you can come to another agreement. But with an IRA, the IRS is always a concern, so before you make any decisions, you need information on how actions regarding your IRA can influence your tax situation.
What is an IRA?
An IRA is an Individual Retirement Account. It’s an account that allows you to save up for retirement with tax-free growth or on a tax-deferred basis. Many people open an IRA to supplement their employer sponsored plan. An IRA owner also potentially has more freedom to invest than they might with their 401 k or other employer-based retirement plans.
What are Distributions?
Distributions refer to taking money out of the IRA early, and taking distributions can mean paying the IRS in what’s known as 10 early distribution–the IRS will claim a 10 percent fee.
There are three types of IRAs:
When you contribute to a traditional IRA, you may be able to deduct that money on your tax return. Up until you withdraw funds at retirement, your earning may be able to grow tax-deferred. When you retire, you are likely to be in a lower tax bracket, and with the tax deferral, the money may be taxed at a lower rate.
With a Roth IRA, the money you contribute has already been taxed, but it may be able to grow tax-free, and you may be able to withdraw it tax-free at retirement. Roth IRAs must meet certain conditions for money to be withdrawn without being taxed.
This is a traditional IRA you contribute to with funds rolled over from an employer-based retirement plan. You are basically transferring retirement assets from your employer plan to an IRA account.
Is an IRA a Marital Asset?
If the IRA consists of contributions made while you were married, then the IRA is a marital asset and is property of both you and your spouse. That means in the event of divorce, retirement plan assets, IRAs, and similar retirement accounts will have to be split up and distributed like all other shared property. Unless another agreement is reached, you will likely need to transfer a portion of the IRA to the other party.
Unlike other assets that must be divided in the divorce, IRAs can incur tax penalties/withdrawal penalties, so tax consequences must be considered when couples consider their options for distributing IRA assets. Because tax rules in regards to IRA funds can be very complex, the best course of action is often to consult with a financial institution or professional accountant before either spouse makes a decision.
Can a Divorcing Couple Cash Out an IRA?
In many cases, taking money from retirement assets before age 59 incurs a penalty (10 penalty). If you are not age 59 and plan to withdraw funds from an IRA, the internal revenue service will hit you with a 10 percent penalty, and you will also owe income tax on the money that year. In divorce, there are better ways to divide retirement savings with your ex spouse than to simply withdraw the cash in an IRA account. Be sure you have all the information before making a costly mistake.
How Can a Couple Split an IRA?
You can give your ex spouse a portion of the IRA through a transfer incident. The owner of the IRA will transfer the desired portion according to IRS rules, and those IRA assets then become property of the former spouse. If the receiving spouse takes distributions, they will be subject to the 10 penalty on those distributions. But as long as all rules are followed and considering no distributions are taken, both the owner and receiving spouse can avoid the 10 penalty and other tax through an IRA transfer.
Are there alternatives to splitting the IRA?
When you choose divorce mediation, you and your spouse have many more options when it comes to splitting up your assets. In fact, if both spouses are in agreement, you can do almost anything you want. One spouse can keep ownership of the IRA while the other keeps something of equal value, such as the family home. Or one spouse can give the other a payment from another source. With mediation, it’s up to the two of you and the mediator you’re working with to arrive at an equitable arrangement. In regards to IRA money, one thing you and your former spouse will want to take into consideration is avoiding a withdrawal penalty.
That being said, before you take any action, make sure you won’t be subjecting yourself to tax consequences. Sometimes, and depending on the situation, tax penalties can be avoided through an IRA transfer.
Transferring an IRA
Usually when couples divorce and divide their property, including most financial assets, that property is not subject to federal tax; it’s considered a gift from one spouse to the other. However, if an IRA owner withdraws funds from the IRA to give to anyone–including the recipient spouse–that money is taxable.
Luckily for couples going through divorce, there’s an exception. If one spouse transfers their interest in the IRA to the other pursuant to a divorce or a separation agreement, those IRA funds are not taxable to either individual. There are some crucial conditions that must be met according to federal law for the couple to avoid penalties.
One, this is a privilege enjoyed only between spouses. IRA funds cannot be transferred to anyone else (like children)–even as part of the divorce decree or separation agreement–or income taxes will be owed on that money.
Two, the IRA transfer remains tax-free only if you and your former spouse do eventually divorce or separate. To avoid income tax on the transfer, it must be specified in the divorce decree or property settlement. In such transfers, the IRA becomes property of the recipient spouse.
Three, to avoid the wrath of the internal revenue service–something you would be wise to do–ONLY transfers incident to divorce are not subject to taxes. The transfer incident cannot be a way to cover support or alimony… or you will owe taxes. Of course, you can work out an arrangement with your spouse in mediation to include the IRA funds in the divorce settlement in lieu of something else. Individuals in mediation can address IRA assets in any way they feel is fair. It makes sense to both the IRA owner and ex spouse to avoid taxes if possible, though, and transfers incident to divorce are one way to make sure you’re keeping as much of your funds as possible.
Qualified Domestic Relations Order (QDRO) and Your Retirement Accounts
What is a Qualified Domestic Relations Order?
You’ve seen how you and your ex spouse can avoid a tax penalty by transferring an IRA through the divorce decree. You can divide funds from other retirement plans with your spouse in a similar manner, but qualified retirement plan assets must be managed by QDRO. Basically, QDRO covers any retirement account that isn’t an IRA. To avoids delays in the divorce and complications, make sure you delineate assets depending on the type–IRAs fall under transfers incident to divorce; every other type under QDRO–on your divorce settlement and property settlement agreement.
Considering the complex rules and possible penalty charges regarding IRA assets in divorce, both the IRA owner and ex spouse may be wise to seek information from a financial professional or mediator familiar with IRAs and how they relate to divorce.
For more information about transfer options, QDRO, IRS penalties to either spouse, or to answer questions you or your former spouse have about the mediation process and how it can benefit you, call the office today to schedule a free consultation.
What is collaborative divorce and how is it different from divorce mediation? Collaborative divorce is similar to mediation in that spouses avoid a divorce judgment through the court, but there are important differences. Spouses each hire an attorney trained in collaborative divorce, and they may also need the services of other professionals with regards to finances and children. Each spouse meets with their attorney separately, and then both spouses and their attorneys arrange a four-way meeting. Normally, attorneys agree to withdraw from the case if it cannot be settled without going to court.
If an agreement is reached, spouses finalize the divorce before a judge in a simple procedure that does not involve a contentious court hearing.
This process has two main disadvantages. The first is the cost of hiring attorneys, as mediators are usually much less expensive. The second disadvantage is that if the couple is unable to resolve their issues and the case must go to court, each of them will have to hire a new attorney and start the divorce over from scratch.
Lawyers in Divorce Mediation
Family mediation is often held without each partner including an attorney. Mediation includes legal advice and eventually, filing your paperwork with the court. Both partners build an attorney client relationship with their mediator as they learn to communicate with each other, rather than facing off. This keeps costs low and ensures the ultimate agreement arises from communication and compromise during mediation.
However, if your ex insists on having their attorney present, then both parties should be represented. Some people choose to hire a consulting attorney for the purpose of mediation, but generally, mediators can help both parties understand their legal positions and reach an agreement.
At your first consultation, your mediator helps you understand the process and gets a better idea of the issues you might be facing–your financial landscape, whether there are children involved in the divorce, and so on. The mediator may gather additional information about your case or ask you to collect information to bring with you in the future. At this stage, the mediator helps you understand what to expect and will explain the limitations of mediation. If both parties agree to proceed, you will schedule mediation sessions, during which you will both come to an agreement on everything previously discussed: finances, property, children. Every divorce is unique, and some people require more mediation sessions than others to address their issues, but most people can come to an agreement within a few months.
At Win-Win, your initial thirty-minute consultation is free, so you can learn about divorce mediation basics and speak with a mediator at no risk.
Working Toward a Settlement Agreement
Sometimes people worry about conducting their divorce through mediation because they believe the will never be able to come to an accord with their ex. But even in difficult cases, mediation is almost always successful, and the mediator may be able to suggest solutions to your issues that neither of you considered. As previously described and noted elsewhere on this website, mediation has tremendous advantages over resolving divorce in court and leaving decisions about your future in the hands of a judge.
The mediator will work equally with both parties–never taking sides–until they agree on each and every one of the issues related to the divorce. Only then will an initial agreement be drafted from everything discusses in mediation as well as through phone calls, text messages, and emails, and parties will have seven to ten days to review it before the mediator will schedule a time for them to sign.
Mediation concludes when the Divorce Packet, which includes the Agreement and other required paperwork, is filed by the mediator on your behalf. In four to six months, a judge will sign the paperwork, and your divorce will be complete.
We hope this information has given you a better understanding of the basics of mediation and how it can help you through your divorce as painlessly as possible. To learn more, call our office and schedule a free consultation with a mediator today.