Two ways to split an IRA during divorce

Failure to follow proper protocol when transferring an IRA can lead to a surprise tax bill.

Retirement assets are notoriously difficult to split during divorce. One wrong step can result in an unexpected tax bill. A recent case out of Michigan provides an example. During that divorce, the husband agreed to distribute a portion of an IRA account to his soon to be ex-wife. To complete the agreement, he transferred the agreed upon amount from the IRA into a checking account to distribute to the wife. Six years later, the IRS accused the man of failing to pay $140,000 in taxes on the transfer.

A transfer of an IRA account without a tax penalty is possible. There are generally two options: change the name on the account to the intended beneficiary or transfer the funds from the IRA account into another IRA. It is important to carefully outline the details of the transfer within the divorce settlement agreement. It is also wise to include information within the agreement on who would be responsible for any fees that could result from the transfer. A failure to address these issues can result in costly litigation.

What went wrong in the case above? One of the agreements in the contentious divorce proceeding that led to the tax bill noted above was a requirement the husband transfer $100,000 from his IRA into the future ex-wife's. The divorce decree specifically stated the transfer would be made from one IRA into another IRA "appropriately tilted in [the other party's] name."

Instead of following this order, the husband transferred the funds from his IRA into a checking account. The parties to this case also filed a joint tax return during the year of the transfer and failed to account for the money within their taxable income. The parties argued that the believed transfers subject to the divorce were non-taxable - the IRS disagreed.

Certain transfers from IRAs made subject to a divorce are tax free. However, the IRS presented evidence to establish that these transfers were not subject to the divorce. Instead, the agency argued the transfers were regular distributions. Evidence used to support this claim included the fact the transfers were not made into another IRA account and that a portion of the transfers from the husband's IRA did not go to the ex-wife. As such, the agency argued the distributions were subject to income taxes. Ultimately, the court ruled in favor of the IRS.

What can other couples learn from this case? Transfer of retirement assets is complex. A failure to follow proper procedure can result in an enormous tax bill. Those going through a divorce can mitigate this risk. An attorney can help tailor a divorce decree to account for various types of retirement assets and specifically outline the procedures needed to transfer the assets. This can greatly reduce the risk of any surprise bills in the future.