While the divorce rate in Maine is below the national average, it is still common. Divorce is obviously an emotionally and personally impactful event. But beyond that, it is also a financially impactful one. A divorce can create negative tax consequences, especially in terms of dividing up tax-favored retirement accounts. Here is how to manage a divorce from a financial perspective to help result in the best tax results possible.
Tax-Smart IRA Rollovers
IRAs can be divided without major consequences. Federal income tax rules allow for a tax-free rollover of money from an IRA into an IRA that’s in an ex’s name. An ex-spouse can manage the rollover IRA and defer taxes until they begin taking money out of the account. This ensures that the original account holder will not owe resulting income taxes.
For federal tax purposes, all IRAs — traditional IRAs, Roth IRAs, SEP accounts and SIMPLE IRAs — follow this rule.
Though these rules seem simple, they come with a rather large caveat: The tax-free rollover only applies when your divorce agreement requires the rollover.
If money from a joint IRA is transferred to an ex-spouse’s rollover IRA before the divoce is finalized or without a requirement in place, the money will be treated as if the original account holder received it. That means that person is responsible for related taxes — even if they didn’t ultimately keep the money. And if this occurs before the age of 59 ½, there is usually a 10% penalty tax.
To avoid this situation, never transfer IRA money prior to the legal requirement in a divorce settlement is in place and says to do so.
Qualified Retirement Plans
Establishing a qualified domestic relations order (QDRO) can help divide qualified retirement plans without incurring an unwelcome tax hit.
Boilerplate language in a divorce agreement can specify how to split up:
- Qualified retirement plans at work, such as 401(k) plans
- Self-employed or small business qualified plans, such as Keogh or corporate profit-sharing plans
- Defined benefit pension plans
The QDRO gives an ex-spouse a legal right to receive a designated percentage of a retirement account balance or designated benefit payments from a plan. This also ensures that the ex-spouse is responsible for the related payouts from the plan. This arrangement also permits an ex-spouse to withdraw their respective share and roll it over into a tax-free IRA — as long as the plan permits it.
A QDRO helps make the division of retirement accounts fair for both spouses, as each is responsible for their related share of taxes. Without a QDRO in place, money taken out of a retirement plan is viewed as if one party took it out, and that person will be responsible for the taxes while the other party gets tax-free money.
This scenario can be even worse if an extra large taxable transfer is made. A large withdraw can push an individual into the maximum 37% federal income tax bracket, cause part or all of the investment income subject to the 3.8% net investment income tax (NIIT) and disqualify them from tax breaks due to income-based phase-out rules.
And on top of all of that, the 10% early distribution penalty tax comes into play if the distribution happens before you’ve reached age 59½.
Needless to stay, QDRO language is very important in divorce agreements.
For More Information
There are a lot of needs to consider when going through divorce, and financial ones definitely need to be among them. If parties have been married for many years and have accumulated a substantial amount of wealth, divorce can be even more complicated. If you need assistance considering the financial impacts of a divorce, contact us at Filler & Associates for help devising various settlement options — including asset allocations and support payments — that minimize potential taxes and meet other personal objectives.