Divorce involves the division of the parties’ retirement accounts. Since distributions of retirement accounts are taxable, and premature distributions are penalized, we need to keep a close eye on the tax treatment of any distributions we make to avoid unpleasant surprises at tax time. Two situations typically arise in divorce: (a) a distribution from a retirement account to pay expenses; and (b) a division of a retirement asset as part of the division of marital property.
Let’s say Husband has an individual retirement account. During a divorce Husband may need money to pay expenses, such as attorney’s fees. He can take a withdrawal from his IRA anytime he wants. But such a withdrawal is both taxed as income and, if Husband has not yet reached the age of retirement, penalized with an additional 10% tax. The administrator of the IRA will automatically withhold 20% of the distribution as a prepayment toward the tax. If Husband wants to receive $20,000 he will need to take out $25,000 because the administrator with automatically deduct $5,000 (20%). Depending on the Husband’s income tax bracket, when he files his taxes he may have to pay more, or he may get money back.
If instead of paying expenses Husband needs to transfer a share of the IRA to Wife, either as part of a settlement agreement or as part of a court order, then Husband provides the plan administrator with the necessary paperwork and the IRA administrator sends a check. The Husband pays no taxes or penalties as a result of this transfer, but Wife may:
1. If the check is sent directly to Wife, then it is taxable income to Wife. Wife does not have to pay the 10% penalty. The plan administrator will withhold 20% as prepayment of wife’s taxes. If Wife promptly deposits the check in her own IRA she does not have to pay the tax and will get the 20% back when she files her taxes.
2. If the check is sent directly to the administrator of Wife’s IRA there is no tax and no withholding.
Obviously, we want to avoid paying the taxes and the penalties, but sometimes Husband or Wife may need the cash in hand.
Retirement account division is complex and tricky. Each type of retirement asset, pension, IRA, 401(k), etc., has its own rules and procedures. An experienced divorce lawyer can guide you through the maze of property division.