Many times when individuals divorce the IRA is split between the spouses. This is done through the divorce decree or separation agreement. An IRA is never split using a qualified domestic relations order (QDRO). That is only used for splitting employer plans, such as 401(k)s.
The paperwork should be very clear on the details of the split. Generally, a percentage is the best way to go. It will take into account any gains or losses in the IRA between the time the document is drafted and the time the account is actually split. A specified dollar amount can be problematic if there is a significant change in the account balance. If there is a large gain, the ex-spouse may not end up with a fair amount, but if there is a large loss, the owner of the account may end up with a much smaller share of the account. Another consideration is costs involved in splitting the account. It should be clearly stated how those costs should be apportioned if there are any.
IRA assets should be directly transferred to the ex-spouse. This can only be done after all the legal paperwork has been finalized. Any withdrawal of funds prior to the finalization of the paperwork results in a taxable distribution to the IRA owner and cash being received by the ex-spouse. Any withdrawals by the IRA owner or by the ex-spouse, once the funds are in their own IRA, will be taxable and subject to the 10% early distribution penalty, if applicable.
There is an additional twist when the IRA owner is over the age of 70 ½ and has a required distribution from their IRA for the year of the split. The RMD is based on the prior year end market value. Let’s take a look at what happens when Lisa, who is 72, gets divorced from Danny.
Lisa’s IRA had a balance of $200,000 as of December 31st last year. The IRA will be split in half with Danny getting 50% of the IRA. Lisa has an RMD of $7,813 ($200,000 / 25.6 = $7,812.50). Her RMD amount will not change. Even after transferring half of her account to Danny, her RMD will remain $7,813.
Danny does not have to include the $100,000 received from Lisa in his RMD calculation for the year because it was not in his IRA on December 31st. Half of Lisa’s required distribution is not transferred to Danny along with half of her account balance.
Now let’s change the scenario a bit. Lisa is transferring her entire IRA to Danny as part of the divorce settlement. It is Lisa’s only IRA account. She transfers the entire account to Danny in June before taking her RMD.
What happens to Lisa’s RMD for the year? There is no guidance from IRS on this scenario. The conservative approach would be for Lisa to take the RMD before moving the account to Danny.
But, there is a provision in the regulations that says if an IRA owner’s account balance declines to less than the required distribution, the owner takes out the remaining balance and is not penalized. If the account balance goes to zero, there is no required distribution and no penalty. Can Lisa rely on this provision to escape the penalty for not taking her RMD? This is a riskier approach since there is no guidance telling us that IRS or the Tax Court would accept this argument.