Lynn Brenner's Family Finance

How to Divide Retirement Accounts in a Divorce Without Triggering a Tax Bill

Q:  My husband and I are getting divorced after 20 years. How should we divide our IRAs and 401(k) accounts so that we don't trigger an income tax? --KG via email

A: With a court order, and only after consulting a tax accountant to make sure you're doing it right!

First, the basic rules:

The division of marital assets in a divorce depends partly on state law. In a community property state, assets are divided equally. In an equitable division state, they're divided equitably. There's an important difference. Equitable' doesn't mean equal; it means fair. It's up to the court to decide what's fair. But when a couple has been married for many years, fifty/fifty is usually deemed to be an equitable split.

What is a marital asset? It's anything that was acquired during your marriage, no matter whose name it's in. This includes the appreciation in your retirement plans. If your IRA was worth $20,000 when you got married, for example, and it's now worth $70,000, the $50,000 increase in value is a marital asset.

When retirement assets are correctly divided in a divorce,  there's no income tax or early withdrawal penalty on the money. `Correctly' is the key word.

If John withdraws money from his IRA, and gives it to Jane, he'll be taxed on that withdrawal. Instead, John must give his IRA custodian a copy of the couple's divorce or separate maintenance decree.

This court-approved document instructs the custodian to transfer an agreed-upon portion of John's IRA into a new IRA in Jane's name. The same order directs Jane to set up a new IRA in her own name to receive the money. (Jane's IRA doesn't have to be at the same institution; it can be opened anywhere. If she opens it at a different institution, the money must be transferred directly from John's IRA custodian to Jane's IRA custodian.)

To divide an employer-sponsored retirement plan like a 401(k) or 403(b) plan, you must give the plan administrator a court order called a qualified domestic relations order, or QDRO.

The plan administrator then divides the account in two. Your former spouse can elect to roll his or her share of your 401(k) into an IRA. 

If your ex doesn't transfer the money into a retirement account, he or she will owe income taxes on it. But in divorce cases, the Internal Revenue Service waives the 10% early withdrawal penalty that would normally apply to distributions by people who are under age 59 and a half.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

FILING TAXES DURING A DIVORCE

Q: I'm a New York resident in the process of getting a divorce. Due to an order of protection, my husband was ordered out of the house in September. My question to you is about filing a 2008 tax return.  Do I file married filing separately or jointly? (I have been paying the mortgage on our second vacation house, and I make significantly less than my husband.) If we do file jointly, do we split the refund? -- PV via email

       

A: Don't make this decision without consulting both your divorce lawyer and your tax accountant -- and don't make it on financial grounds alone. It's possible that filing a separate return will result in a higher tax bill. But even if that turns out to be the case, do you really want to file a joint return with someone you had to have ordered out of your house for your own protection?

       

That said, here's a rundown of the financial and legal factors to be considered: 

       

A married-filing-separately tax status usually results in a higher tax bill than a joint filing. But ask your accountant to run the numbers for you. In your case, filing separately might actually save you money by letting you report a much smaller income and claim bigger deductions. 

       

When you file jointly, you have to share deductions, says Alan E. Weiner, senior tax partner at Holtz, Rubenstein, Reminick in Melville -- but if you file separately, you can claim all the payments you made on the vacation house. And as a separate filer, you wouldn't have to share the refund, if there is one. 

       

Filing separately also makes sense if you suspect that your husband underreports his income. Signing a joint return exposes you to prosecution by the IRS. True, you can avoid liability as an innocent spouse who didn't know he was lying -- but the success of that defense depends partly on the circumstances, says Stephen W. Schlissel, a Garden City divorce attorney. It's unlikely to fly, for example, if your joint return claims a $100,000 income and you live in a $4 million house.

       

Schlissel says that even if the IRS doesn't challenge a joint tax return that understates your husband's income, it  could result in reducing your divorce settlement. Let's say the tax return states that he makes only $100,000, although he really makes much more. If you sign that return, you may be precluded from claiming in divorce court that his income is more than $100,000. 

       

"No one in the midst of a divorce should sign a joint tax return without first obtaining an indemnification letter from his or her spouse," Schlissel says. "The indemnification letter states that neither party in the divorce litigation is bound by what's on the tax return. It also addresses what happens if one party lied in underreporting income or overstating deductions." 

       

Of course, the IRS isn't a party to this agreement. If your joint tax return understates income, the government comes after both of you. But an indemnification letter would give you grounds to sue your former spouse to recover any additional taxes, interest, and penalties the IRS demands from you as a result of his lies. 

       

The indemnification letter also addresses how the couple will handle any additional taxes due or refunds arising from their joint return. In 99% of divorce cases, Schlissel says, the parties agree that any tax refund will go into an escrow account pending the divorce settlement.

BASIC ADVICE FOR DIVORCING COUPLES

Try to divide your assets sooner rather than later. It’s comforting to feel in control of your own money at a time when you don't feel in control of anything else. And you can’t really separate while you still own everything together.  

Some assets are harder to divide than others. It’s worth paying for legal help to do it right because it can save you huge amounts of money, to say nothing of grief.  

• Ask a judge to divide your employer-sponsored retirement accounts. The judge sends a QDRO -- a qualified domestic relations order -- to the 401(k) plan administrator, who splits one account into two. A similar court order can divide IRAs without triggering any taxes. The order goes to both spouses. It tells the one who owns the IRA to give the IRA custodian (the bank or mutual fund that holds it) written instructions to transfer part of the money into a new IRA in the other spouse's name. And it tells the second spouse to set up an IRA to receive the money.

• Think twice about taking the house in exchange for letting your former spouse take the retirement account money. A house costs a lot to maintain and it doesn't generate income. As a rule, you're much better off selling it and splitting the profits than opting to stay in a home you can't afford.

• If you have a jointly-owned business, negotiate a cash buyout.

• Make sure your divorce settlement says how you and your ex will share your child's expenses after he turns 18.

• Talk about how you'll handle this year's tax return. "If you file conflicting tax returns, you're putting a neon sign in front of the IRS," says one divorce lawyer.