The Tax Impact of Splitting an IRA at
Divorce
Generally, under IRC Section 72(t), any amount distributed from an IRA is taxable as ordinary income to the payee or distributee. One of the exceptions to this rule, however, is found in IRC Section 408(d)(6) and pertains to distributions made pursuant to a divorce.
A transfer of an individual’s interest in an IRA to his or her former spouse under a divorce or separation instrument is not considered a taxable transfer. Sounds pretty straightforward, right? Well, missteps in this area are not uncommon, and failure to abide by the requirements set forth in IRC Section 408(d)(6) can result in a substantial tax liability for one of the spouses.
Avoiding a Taxable Event
Two requirements—seemingly basic—are set forth under IRC Section 408(d)(6). To avoid triggering a taxable event when transferring an interest in an IRA in a divorce action: (1) There must be a transfer of the IRA participant’s interest in the IRA to his or her spouse or former spouse; and (2) such transfer must have been made under a divorce or separation instrument. Tax Court cases have analyzed the mechanics and circumstances of certain IRA transfers to determine if they run afoul of IRC Section 408(d)(6).
In Jones v. Commissioner (TC Memo. 2000-19), the marital settlement agreement between the parties called for the husband to transfer his IRA to his wife. However, the husband cashed out the IRA and endorsed the $68,000 check to his wife. It was the IRS’s position that the $68,000 should be included in the husband’s income for that year. The court took the strict approach—based on the language in IRC Section 408(d)(6)—that a “transfer” did not occur. The husband cashed out the IRA and, in doing so, ran afoul of the statute.
The transfer of IRA assets by a distributee is not what the statute contemplates, the court reasoned. The “transfer” must be an exchange, not a distribution. Also, one cannot allocate to a non-participant spouse the tax burden of an actual distribution.
Cashing Out an IRA Balance
Bunney v. Commissioner [114 TC No. 17 (2000)] also illustrates the pitfalls of not handling the IRA transfer properly. In this case, the divorce settlement called for the husband’s IRA to be split equally, as it was funded with community property. The husband withdrew the $125,000 balance from his IRA and deposited the proceeds into his money market fund. Later that year, he transferred $111,600 to his wife, representing his net responsibilities under their divorce agreement. On his federal income tax return, the husband only reported $13,400 of his IRA distribution proceeds as income.
The main issue in the case: whether the husband’s gross income should include the entire $125,000 distribution from his IRA. Similar to Jones, by cashing out his IRA, the husband here failed to meet the definition of a transfer of his IRA interest.
Trustee-to-Trustee Transfer
Another Tax Court case, Cohen v. Commissioner (TC Memo. 2004-227), addresses a different facet of the process of dividing an IRA in a divorce action. In this case, the court ordered that the ex-husband’s IRA—amounting to approximately $120,000—be divided equally. The ex-wife established an IRA in her own name, and the ex-husband transferred $60,000 from his IRA directly into her IRA via a trustee-to-trustee transfer. The ex-wife later requested and received a distribution of her IRA in the amount of $60,000 in the form of a check.
Mrs. Cohen did not report the $60,000 distribution from her IRA as income on her tax return for that year. She argued that the $60,000 at issue should be deemed taxable income to her ex-husband—not her—as it represented a distribution from his IRA. She contended that, as a result of this cash transfer representing marital assets, she had a $60,000 cash basis in her IRA. Therefore, she reasoned, her $60,000 distribution from her IRA was a tax-free event.
Before the Tax Court, Mrs. Cohen’s position centered around the idea that the governing divorce document didn’t explicitly call for the creation of a new IRA to receive the transfer from the ex-husband. Therefore, she believed the transfer ran afoul of IRC Section 408(d)(6). The court disagreed, noting that the order specifically instructed her ex-husband to transfer a 50% interest in his IRA to her, which he had done.
Intent Should Be Clear
When splitting up an IRA as part of a divorce, it is advisable to be as clear as possible in the divorce decree, separation agreement or other controlling document. Consider including language that clearly spells out the parties’ intent that the IRA transfer is intended to fall within the IRC Section 408(d)(6) exception.
Generally, under IRC Section 72(t), any amount distributed from an IRA is taxable as ordinary income to the payee or distributee. One of the exceptions to this rule, however, is found in IRC Section 408(d)(6) and pertains to distributions made pursuant to a divorce.
A transfer of an individual’s interest in an IRA to his or her former spouse under a divorce or separation instrument is not considered a taxable transfer. Sounds pretty straightforward, right? Well, missteps in this area are not uncommon, and failure to abide by the requirements set forth in IRC Section 408(d)(6) can result in a substantial tax liability for one of the spouses.
Avoiding a Taxable Event
Two requirements—seemingly basic—are set forth under IRC Section 408(d)(6). To avoid triggering a taxable event when transferring an interest in an IRA in a divorce action: (1) There must be a transfer of the IRA participant’s interest in the IRA to his or her spouse or former spouse; and (2) such transfer must have been made under a divorce or separation instrument. Tax Court cases have analyzed the mechanics and circumstances of certain IRA transfers to determine if they run afoul of IRC Section 408(d)(6).
In Jones v. Commissioner (TC Memo. 2000-19), the marital settlement agreement between the parties called for the husband to transfer his IRA to his wife. However, the husband cashed out the IRA and endorsed the $68,000 check to his wife. It was the IRS’s position that the $68,000 should be included in the husband’s income for that year. The court took the strict approach—based on the language in IRC Section 408(d)(6)—that a “transfer” did not occur. The husband cashed out the IRA and, in doing so, ran afoul of the statute.
The transfer of IRA assets by a distributee is not what the statute contemplates, the court reasoned. The “transfer” must be an exchange, not a distribution. Also, one cannot allocate to a non-participant spouse the tax burden of an actual distribution.
Cashing Out an IRA Balance
Bunney v. Commissioner [114 TC No. 17 (2000)] also illustrates the pitfalls of not handling the IRA transfer properly. In this case, the divorce settlement called for the husband’s IRA to be split equally, as it was funded with community property. The husband withdrew the $125,000 balance from his IRA and deposited the proceeds into his money market fund. Later that year, he transferred $111,600 to his wife, representing his net responsibilities under their divorce agreement. On his federal income tax return, the husband only reported $13,400 of his IRA distribution proceeds as income.
The main issue in the case: whether the husband’s gross income should include the entire $125,000 distribution from his IRA. Similar to Jones, by cashing out his IRA, the husband here failed to meet the definition of a transfer of his IRA interest.
Trustee-to-Trustee Transfer
Another Tax Court case, Cohen v. Commissioner (TC Memo. 2004-227), addresses a different facet of the process of dividing an IRA in a divorce action. In this case, the court ordered that the ex-husband’s IRA—amounting to approximately $120,000—be divided equally. The ex-wife established an IRA in her own name, and the ex-husband transferred $60,000 from his IRA directly into her IRA via a trustee-to-trustee transfer. The ex-wife later requested and received a distribution of her IRA in the amount of $60,000 in the form of a check.
Mrs. Cohen did not report the $60,000 distribution from her IRA as income on her tax return for that year. She argued that the $60,000 at issue should be deemed taxable income to her ex-husband—not her—as it represented a distribution from his IRA. She contended that, as a result of this cash transfer representing marital assets, she had a $60,000 cash basis in her IRA. Therefore, she reasoned, her $60,000 distribution from her IRA was a tax-free event.
Before the Tax Court, Mrs. Cohen’s position centered around the idea that the governing divorce document didn’t explicitly call for the creation of a new IRA to receive the transfer from the ex-husband. Therefore, she believed the transfer ran afoul of IRC Section 408(d)(6). The court disagreed, noting that the order specifically instructed her ex-husband to transfer a 50% interest in his IRA to her, which he had done.
Intent Should Be Clear
When splitting up an IRA as part of a divorce, it is advisable to be as clear as possible in the divorce decree, separation agreement or other controlling document. Consider including language that clearly spells out the parties’ intent that the IRA transfer is intended to fall within the IRC Section 408(d)(6) exception.
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