The Tax Consequences of Dividing Retirement Assets at Divorce

By John C. Zimmerman

One of the worst scenarios in a divorce proceeding is for someone to transfer retirement assets to a former spouse and then be liable for the taxes, including penalties. Ways to avoid this include the use of a qualified domestic relations order or an IRA. However, as the author points out, it must be done very carefully.

In Karem (100 TC S21) a husband transferred money to his wife from his qualified retirement plan. The Tax Court held he was taxable on the transfer. The Tax Court also ruled that community property laws would not prevent the full amount of the transfer from the qualified plan from being taxable to the plan participant spouse.

Qualified Domestic Relations Orders

Karem illustrates the problem that arises when a transfer from a qualified retirement plan is made pursuant to a divorce and there is no qualified domestic relations order (QDRO). A QDRO will prevent adverse tax consequences to the transferor spouse. IRC Sec. 402(e)(1)(A) provides that the payee spouse is taxable on the full amount of the transfer. However, the payee spouse may roll over the amount into his or her own IRA or qualified retirement plan or may forward average on form 4972 if the plan participant spouse qualifies for forward averaging.

The recipient of a QDRO is known as an alternate payee. If the alternate payee is not the transferor's spouse (e.g., a child), the transferor will be taxable on the distribution. However, regardless of who is liable for the tax, IRC Sec. 72(t)(2)(C) provides that no 10% premature withdrawal penalty will be imposed when the distribution is made pursuant to a QDRO. When there is no QDRO, such as in Karem, the participant spouse may also be liable for the 10% premature withdrawal penalty if he or she is not 59Aw when the transfer is made. Also, neither the 15% excess distribution tax nor 15% excess accumulation tax for estates of IRC Sec. 4980A apply to a distribution made pursuant to a QDRO.

Definition. A QDRO is defined in IRC Sec. 414(p)(1) as a domestic relations order, usually issued by a state court, that creates or recognizes an alternate payee's right to receive all or a portion of the benefits of a qualified plan, including IRC Sec. 403(b) plans. A domestic relations order is defined in IRC Sec. 414(p)(1)(B) as any judgment, decree, or order (including approval of a property settlement agreement) that 1) relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependents of a plan participant; and 2) is made pursuant to a state domestic relations law (including community property law).

Requirements. IRC Sec. 414(p)(1) only applies to qualified plans that meet the requirements of IRC Sec. 401(a). Non-qualified plans do not qualify for a QDRO. IRC Sec. 414(p)(2) states the QDRO must clearly specify the following:

* The name and last known mailing address (if any) of the plan participant and each alternate payee.

* The amount or percentage of the participant's benefit to be paid by the plan to each alternate payee, or the manner in which the amount or percentage is to be determined.

* The number of payments or period to which the order applies.

* Each plan to which the order applies.

IRC Sec. 414(p)(3) states the domestic relations order cannot require--

* a plan provide any type or form of a benefit, or any option, not otherwise provided under the plan;

* the plan to provide increased benefits (determined on the basis of actuarial value); and

* the payment of benefits to an alternate payee required to be paid to another alternate payee under a previous QDRO.

The prohibition against a domestic relations order providing a benefit not otherwise available under the plan is not violated if payments to the alternate payee are made before the plan participant has separated from service, or after the participant attains or would have retained the earliest retirement age. IRC Sec. 414(p)(4)(B) defines the earliest retirement age as the earlier of--

1. the date on which the participant is entitled to a distribution under the plan; or

2. the later of the date the participant reaches age 50 or the earliest date on which the participant could begin receiving benefits under the plan if separated from service.

For example, suppose a profit sharing plan participant is entitled to receive a distribution upon attaining age 65 or when he or she separates from service. However, in no event can he or she receive a distribution until age 55. The plan could make a distribution to the alternate payee once the participant attained age 55, even if he or she had not separated from
service. However, the amount paid to the alternate payee
cannot exceed the amount
the participant would be entitled to receive at the date of
distribution.

Plan administrators must notify the participant and each alternate payee when the plan receives a domestic relations order. The administrator must also determine if the order is a QDRO. Each plan must establish reasonable procedures to determine the qualified status of an order and how to administer distributions. Notices must be sent to addresses specified in the order or to the last known address of the participant or alternate payee if the order does not specify an address. Payment of benefits may be delayed for a reasonable period of time if a plan administrator receives a notice that a domestic relations order is being sought.

A plan administrator or court of competent jurisdiction must segregate amounts that would be payable while attempting to determine whether an order is a QDRO. IRC Secs. 414(p)(7)(B) and (E) provide that if within the 18-month period beginning with the date on which the first payment would be required to be made under the domestic relations order,
the order is found to be a QDRO, the plan administrator must pay the segregated amounts, plus interest, to the
alternate payee.

Possible Problems. Problems may arise because a domestic relations order may not meet all the requirements for a QDRO. As was noted earlier, a QDRO must specify the amount or percentage of benefit to be paid to each alternate payee. In a defined contribution plan this may be a problem if the plan only does quarterly or annual valuations of account balances while a divorce decree specifies some other date. For example, if a divorce decree specifies that an alternate payee is to receive 50% of an account balance as of the date of marital dissolution, February 25, 1996, and account valuations are only done quarterly, the order would not be a QDRO. To avoid this problem the order should state a specific dollar amount.

Problems may also arise in a defined benefit plan because it cannot be divided like a defined contribution plan. Assigning a specific dollar amount from a defined benefit plan could fail a QDRO because a defined benefit is unlike an account balance. In this instance it might be preferable to assign a percentage of the participant's accrued benefit as of the divorce date (providing the plan will make such a valuation) or have the alternate payee receive a monthly dollar amount for the participant's life.

Some plans will offer extra benefits to a participant's spouse not available to children. If a domestic relations order provides that a child payee is entitled to such benefits it will not be a QDRO because of the prohibition against allowing an alternate payee to receive a benefit not otherwise allowable under the plan.

The taxpayer in Karem, cited earlier, did not qualify under the QDRO rules because the marital dissolution agreement failed to specify the items required by IRC Sec. 414(p). It is possible that a nonparticipant spouse may attempt to challenge a purported QDRO as not meeting the literal requirements of IRC Sec. 414(p) to shift the tax burden to the participant spouse. As was noted earlier, distributions from a qualified plan are taxable to the participant unless paid to an alternate payee spouse pursuant to a QDRO.

In Barbara Brotman (lO5 TC No. 12) the alternate payee spouse challenged the enforceability of the QDRO, claiming it did not meet the requirements of IRC Sec. 414(p). The Tax Court refused to rule on the issue since a Federal district court had upheld the order as being a QDRO. However, the Tax Court did rule Brotman could challenge the qualified status of the plan from which the proceeds were distributed. Since a QDRO can only come from a qualified retirement plan, failure of the plan to meet the qualification requirements of IRC Sec. 401(a) would void the QDRO and shift the tax consequences from Barbara to her husband.

In Rodoni (105 TC No. 3), a QDRO was found lacking because the judgment of marital dissolution did not specify the facts required by IRC Sec. 414(p)(2). Also the distribution to Rodoni's spouse was not paid by the administrator or trustee in compliance with a court order that was determined to be a QDRO.

IRA Transfer

The provisions for a QDRO were made a part of the Retirement Equity Act of 1984. After its passage, many retirement plans were amended to make distributions pursuant to a QDRO. However, some plans may not have been amended to handle a QDRO. The whole QDRO process can be very costly and time consuming to a qualified plan. In the event a plan is not able to handle a QDRO, a plan participant can still shift the tax consequences of a plan distribution to the nonparticipant spouse by using an individual retirement account (IRA).

IRC Sec. 408(d)(6) allows an individual to transfer an interest in an IRA to his spouse or former spouse pursuant to a divorce or separation agreement as described in IRC Sec. 71(b)(2)(A). The IRA will belong to the spouse or former spouse, who will be taxable on any IRA distribution. A QDRO cannot be used to divide an IRA because a QDRO only applies to qualified plans. An IRA is not a qualified plan.

The first step in using the IRA to transfer retirement assets is IRC Sec. 402(c)(1), which excludes from taxation amounts paid to an IRA from a qualified plan in an eligible rollover distribution made within 60 days of receipt. An eligible rollover distribution is defined in IRC Sec. 402(c)(4) as "any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified trust." The amount rolled over cannot be an amount in which the employee has a basis (i.e., nondeductible employee contributions). The transfer is not applicable to any distribution that is one of a series of substantially equal periodic payments (not less frequently than annually) made 1) for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and the employee's designated beneficiary or 2) for a specified period of 10 years or more. An eligible rollover distribution also excludes mandatory distributions under IRC Sec. 401(a)(9) for plan participants who reach a certain age.

Another, and perhaps more preferable, alternative is to have the qualified plan make a direct transfer to the IRA pursuant to IRC Sec. 401(a)(31). Direct transfers are becoming a more popular method for transferring funds from qualified plans to IRAs. Qualified plans must inform participants of this option.

The IRS first ruled on the issue of using IRC Sec. 408(d)(6) to divide qualified plan assets in 1979's letter ruling 7948054. Subsequently, the IRS issued three other letter rulings allowing the technique. The plan participants in these rulings wanted to receive amounts from the qualified plan and roll them into an IRA. The participant would then assign an interest in the IRA to his spouse pursuant to a separation or divorce agreement. In each instance, the IRS held that the transaction qualified under IRC Sec. 408(d)(6). The IRS also issued eight letter rulings (most recently 8652071) allowing plan participants to roll over a part of the distribution from a qualified plan into a separate IRA, which is then transferred to the spouse.

It is important that the proposed transfer from the plan to the IRA be made pursuant to separation or divorce. In letter ruling 8820086, a husband wanted to transfer one-half of his IRA to his spouse pursuant to IRC Sec. 408(d)(6). The IRS ruled the transfer would be taxable to the husband because it was not made pursuant to marital separation or divorce. The IRS also held that IRC Sec. 1041, which exempts transfers between spouses from taxation, did not apply.

The form of an IRC Sec. 408(d)(6) transfer must be strictly adhered to in order to avoid adverse tax consequences to the transferor spouse. The section specifically states that the interest transferred to the transferee spouse must be an interest of the transferor. A direct distribution from a qualified plan of the participant spouse to the IRA of a nonparticipant spouse will fail IRC Sec. 408(d)(6) and cause the participant to be taxable. Also, the transferor must actually transfer the whole IRA or an interest in the IRA to the spouse. If proceeds are distributed from the IRA to the payee spouse, IRC Sec. 408(d)(6) will not apply (Paul Harris 62 TCM 406). In Rodoni, the marital dissolution judgment provided that Mrs. Rodoni was to receive a community property interest in her husband's profit sharing plan and the amount would be deposited to her IRA. Rodoni argued the rollover rules had been substantially complied with. The court rejected this argument stating that a taxpayer runs risks whenever he "does not precisely follow the detailed requirements" of the code.

A number of adverse tax consequences occurred in Rodoni because of the absence of a QDRO and the failure to meet the literal requirements of IRC Sec. 408(d)(6). Mario Rodoni not only had to pay income tax on the distribution, but he also had to pay the 10% premature withdrawal penalty for a distribution made before a participant reaches age 59Aw . He was also liable for the 15% excess distribution tax imposed by IRC Sec. 4980A on amounts he received in excess of $150,000. (The 15% tax is reduced by the premature withdrawal penalty attributed to the excess payment.) Mrs. Rodoni had to pay the six percent excess contribution tax applicable to an IRA because she was not eligible for a rollover. She could only rollover if the distribution was made pursuant to a QDRO.

Practitioner's Role

The problems encountered by the taxpayers in Rodoni illustrate the consequences of failing to adhere to the necessary procedures when dividing qualified retirement plan assets at divorce. When a practitioner learns that clients are contemplating divorce, one of the first questions asked should be if either spouse has a qualified retirement plan, and if so, whether the spouses intend to divide the proceeds of the plan. Many times, separating couples will not even consider such a division until divorce attorneys become involved.

If the practitioner learns the clients are considering dividing qualified retirement assets, the next step is to determine whether the plan from which the assets will be distributed provides for a QDRO. The clients should be told why a QDRO is advisable. The practitioner must also ensure the QDRO meets all the requirements of IRC Sec. 414(p). A defective domestic relations order will not be respected by the IRS as a QDRO.

An IRC Sec. 408(d)(6) transfer should only be utilized if the qualified retirement plan does not provide for a QDRO. A QDRO has a number of advantages over IRC Sec. 408(d)(6). With a QDRO, the payee spouse receives the proceeds directly from the retirement plan, and if there is a restriction on distribution, the amounts to which the payee spouse will be entitled are segregated for his or her benefit. IRC Sec. 408(d)(6) requires the participant spouse to have initial control of the retirement plan assets in his or her IRA. The nonparticipant spouse may not like the idea of allowing the participant spouse to have this control. With a QDRO, the alternate payee will not be liable for a premature withdrawal penalty if he or she decides not to roll over. However, a spouse who receives an IRA interest pursuant to IRC Sec. 408(d)(6) may be liable for the 10% penalty if these amounts are withdrawn before reaching age 59Aw . Also, a QDRO offers the transferee spouse the benefit of forward averaging if the participant spouse qualifies, whereas this benefit is not available under IRC Sec. 408(d)(6).

Finally, the practitioner should also be aware of the tax consequences if nonqualified plan assets are divided. Neither a QDRO nor IRC Sec. 408(d)(6) apply to nonqualified plans. In letter ruling 9340032, the IRS stated the normal tax rules apply to nonqualified plans. This means the participant spouse will bare the full burden of taxation in a common law state. In a community property state, where the amounts were set aside during the marriage, each spouse should be liable for his or her share of the deferred compensation. A practitioner may want to advise the parties in common law states that the marital dissolution agreement provides that the nonparticipant spouse who receives a share of the deferred compensation be liable for a portion of the tax imposed on the
participant. *