Divorce? Retirement accounts take tax hit

Source: MARKETWATCH

By Bill Bischoff

Last Update: 7:00 AM ET Jan 9, 2013

In addition to all the other stuff, getting divorced is a major financial transaction. As such, it can have serious tax implications, including some pitfalls youll want to avoid.

This is especially true when it comes to splitting up tax-favored retirement accounts between you and your soon-to-be ex. Youll need to plan ahead to make sure the tax results turn out OK for you. Heres the story.

Use QDRO to divide qualified accounts

Say you have a qualified retirement plan at worksuch as a 401(k) planor a self-employed or small-business retirement program, such as a simplified employee pension plan (SEP). Youll probably have to divide up your retirement account (or accounts) between you and your ex as part of the divorce property settlement. However, doing it carelessly can create a real tax fiasco for you.

To divide up qualified retirement plan accounts the tax-smart way, you need to establish a qualified domestic relations order, or QDRO. Whats a QDRO? Its simply some boilerplate language that should be included in your divorce papers.

First and foremost, the QDRO establishes your exs legal right to receive a designated percentage of your retirement account balance or designated benefit payments from your plan. The good news for you is the QDRO also ensures that your ex, and not you, will be responsible for the related income taxes when he or she receives payouts from the plan.

The QDRO arrangement also permits your ex-spouse to withdraw his or her share of the retirement plan money and roll it over tax-free into an IRA (assuming the plan permits such a withdrawal). That way, your ex can take over management of the money while postponing income taxes until withdrawals are taken from the rollover IRA.

Bottom line: the QDRO is a fair deal for both you and your ex because it ensures that the person who gets retirement plan payouts will also owe the related income taxes. Who can argue with that?

Heres the rub. If money from your qualified retirement plan gets into your ex-spouses hands without a QDRO being in place, you face a potentially disastrous tax outcome.

Youll be treated as if you received a taxable payout from the plan and then voluntarily turned the money over to your ex. So youll owe all the taxes while your ex gets the money tax-free. Even worse, the extra income from a big taxable transfer of retirement account balances could push you into the maximum 39.6% federal income tax bracket, cause some or all of your investment income to be hit with the new 3.8% Medicare surtax, cause some or all of your personal and dependent exemption write-offs to be phased out, and cause some of your itemized deductions be phased out. Ouch!

To add further insult to injury, you might also get stung with a 10% penalty tax if this happens before youve reached age 59.

So make sure your divorce papers include the necessary QDRO language. Helpfully enough, the Feds even provide sample language in IRS Notice 97-11. See page 49 of this IRS bulletin (PDF).

You would think this advice would be so well-known that I wouldnt have to give it. You would be wrong. There have been tons of court cases where individuals turned over retirement plan money to their ex-spouses without bothering with QDROs. Those individuals all wound up getting socked with big tax bills. Not fair to them, but the tax rules are often unfair to folks who dont know what they are doing.

Be careful with IRAs, too

You dont need a QDRO to divide up an IRA between you and your soon-to-be ex without dire tax consequences. You can simply arrange for a tax-free rollover of money from your IRA into an IRA set up in your exs name. Then your ex can manage the rollover IRA and defer taxes until he or she begins taking money out of the account.

As with a QDRO, this procedure ensures that your ex, and not you, will owe the resulting income taxes. These rules apply equally to traditional IRAs, Roth IRAs, SEP accounts, and SIMPLE IRAs (they are all considered IRAs for this purpose).

You still need to be careful here. The nice tax-free rollover deal only applies when your divorce agreement requires the rollover. What happens if money from your IRA gets into your exs hands before or after the divorce without such a requirement? Youll be treated as if you received the money, and youll be on the hook for the related taxeseven though you didnt actually keep the money. Plus youll usually owe a 10% penalty tax if youre under age 59.

To avoid this fate, you should never transfer IRA money to your ex in advance of a legal requirement in your divorce papers to do so.

You can divide up tax-favored retirement account money the tax-smart way or the tax-dumb way. Unfortunately, some otherwise-competent divorce attorneys know little or nothing about taxes. That doesnt cut it.

You need a legitimate tax pro who has handled lots of divorce-related tax issues on your side. While your attorney might be able to fill that role, dont take it for granted. With higher taxes now in effect, this is an even bigger issue than before.

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