HOW TO TRANSFER AN INTEREST IN AN IRA IN CONJUNCTION WITH DIVORCE WITHOUT INCURING EARLY DISTRIBUTION PENALTIES
When an interest in an IRA is to be transferred from one spouse to another in conjunction with divorce, the Internal Revenue Service has attempted to facilitate as easy a transfer as possible. In general, the transferred interest in the IRA is viewed as the recipient-spouse's property and, therefore, this conveyance is tax-free.
The most common method is the direct transfer. The IRA owner-spouse may order the IRA trustee to transfer the necessary IRA assets directly to the trustee of a new or existing IRA in the name of the recipient-spouse. Another option is to transfer the assets the owner-spouse is entitled to keep to another IRA, leave the necessary amount in the old IRA for the recipient-spouse and change the name on the old IRA to that of the recipient.
The transfer of an IRA to an ex-spouse should be made after the divorce is final. If the account owner transfers part or all of an IRA before the divorce judgment is entered, he/she could be taxed on the distribution and possibly incur a 10-percent early-distribution penalty.
A transfer is not considered "incident to divorce" unless it occurs after the final judgment/decree of divorce has been entered by the court. After entry of the divorce judgment, the account owner should transfer an IRA in a timely manner. If a divorce decree does not address the division of an IRA, then a transfer to the ex-spouse will be considered a taxable distribution to the account owner if transferred more than one year after the date of divorce.
Should an individual give IRA assets to a former spouse without receiving a court-approved divorce decree or separation agreement authorizing the change in ownership, the individual will be required to include the amount in his/her income, thus treating the transaction as a distribution to him/herself.
To protect the interests of both spouses, and clearly communicate the parties' intentions to the financial institution/IRA custodian, it is recommended that the parties prepare a domestic relations order setting forth the precise manner in which the IRA will be distributed. The document must address the retirement assets and stipulate how the division should be allocated, that is, whether the assets are shared equally, awarded entirely to one person, awarded partly to one person, etc. Some financial institutions require that the divorce decree reference the retirement account's number and the custodians name. The Order should state that the transfer is specifically ordered "to accommodate the marital/community property distribution between the parties."
In order to avoid confusion and minimize the risk of adverse tax consequences, it is advisable that parties enter into an agreement, similar to a QDRO (although, technically, not a QDRO) that specifically identifies the IRA and the manner in which it will be divided upon entry of the divorce judgment. QDROpedia.com's state-specific sample matrimonial orders for transfer of IRA Funds are available for immediate download, and are very easy to use.
In addition to the foregoing, anyone with an IRA should, upon divorce, update beneficiary designations with his or her IRA custodian. Outdated beneficiary designations can result in unintended heirs.