Establishing an individual retirement account (IRA) is a great way to prepare for the future. Although divorces are rarely foreseeable, separating couples should be aware that dividing an IRA may result in it being subject to income taxes, penalties, or both, if not structured properly. Evidenced in TC Memo 2017-125, the Tax Court has concluded that an IRA split between a divorcing husband and wife is subject to an early distribution penalty.
In this particular case, the couple worked out their own divorce terms without an attorney. Prior to obtaining a court order showing how the martial property will be divided, the husband withdrew his IRA and gave half of it to his wife as part of their settlement. During the transaction, the husband deposited all of the IRA proceeds into their joint bank account and gave the wife her share. Subsequently, the settlement agreement was filed with the court without mention of their self-prepared agreement because the IRA had already been divided.
Unless the withdrawal meets one of a few exemptions, all IRA funds withdrawn before the age of 59½ are taxable and subject to a 10% early distribution penalty. One of these exemptions is a distribution incident to divorce, if structured properly.
IRC 72(t)(2)(C) states that this penalty does not apply to an IRA distribution that is made to an alternate payee pursuant to a qualified domestic relations order. For this code section, the order is defined as a court order to, among other elements, divide marital property rights paid in accordance with the state’s domestic relations law. An alternate payee includes a spouse or former spouse who has the right under an aforementioned order to receive the property.
In this particular instance, the IRA distribution was not made to the spouse and was not made pursuant to a court order. Because of the form of the transaction, the Tax Court determined that this distribution was subject to the 10% penalty.
Tax law is unforgiving and fraught with complexity. These surprises could have easily been avoided if the taxpayers sought out qualified advisors to assist them. If you have questions on this matter or would like to discuss your particular tax situation, please contact Aronson’s Tax Controversy Practice Partner, Larry Rubin, at 301.222.8212 or email@example.com.