Divorcing couples often face the need to split up some retirement account assets. This can be done from a retirement plan such as a 401(k) or 403(b), or from an IRA. Depending on which type of account you’re splitting, the rules are very similar but are referred to by different names. For a qualified retirement plan (401(k) or 403(b) plan), the operative term is Qualified Domestic Relations Order or QDRO (cue-DRO). For an IRA, the action is known as a transfer incident to a divorce.
We discussed the QDRO in several other articles, so we’ll focus on the transfer incident to a divorce in this article.
Transfer Incident to a Divorce
When an IRA is to be divided due to a divorce, the divorce decree will specify this as a transfer of IRA assets incident to a divorce. With this magical language, the original owner of the IRA is allowed to direct all or a portion of the IRA account to his or her ex-spouse’s IRA. This can be done by re-titling the original IRA (if the account is to be fully transferred) or by directing the custodian to transfer a portion of the account to an existing or new IRA in the name of the receiving spouse. The transfer can be done in shares of holdings from the original account, or in cash.
When the transfer occurs, although a distribution has technically occurred from the account, there will be no tax owed by the original owner. In addition, if the receiving owner of the funds leaves the money in the receiving IRA, there will be no tax at the time of the transfer on the funds. Once the money is removed from the receiving account, ordinary income tax would be owed as usual, and perhaps an early withdrawal penalty unless an exception applies.
The major difference between a QDRO and a transfer incident to a divorce is that a transfer incident to a divorce does not allow for the receiving ex-spouse to receive the funds penalty-free if not rolled over into a receiving IRA. With a QDRO, although the funds are taxable to the receiving ex-spouse, there is no 10% penalty if the funds are withdrawn prior to his or her reaching age 59½. If the originating account is an IRA, the 10% early withdrawal penalty will apply in addition to ordinary income tax.