IRA And Divorce: How Taking an Early Distribution Can Affect IRA Split
Retirement accounts can be some of the most complex assets to deal with in a divorce. There are options available to divorcing parties, and there are methods of division that are objectively better for each party. Below, we explore how IRAs are divided in a Texas divorce and how different distribution processes can affect the proceeds. Call a Houston family law attorney for assistance with your Harris County divorce.
How IRAs Are Taxed
An IRA is an individual retirement account. The purpose of an IRA is to allow people to set aside funds in a retirement account that will grow tax-free. An IRA allows people to generate earnings without incurring taxes on things like capital gains, dividends, and interest, but the trade-off is that the funds must not be withdrawn until the indicated retirement age (59½). Withdrawing funds early incurs a penalty (10% plus the ordinary income tax).
There are a few different types of IRAs. The traditional or pre-tax IRA allows the owner to contribute a limited amount of funds each year and take a tax deduction. The contribution and the earnings will be taxed at the time the funds are withdrawn. There are also after-tax IRAs, in which the contributions are not tax-deductible; when withdrawn during retirement, only the earnings are taxed. Nowadays there are also Roth IRAs. With Roth IRAs, the contributions are not tax-deductible, but future distributions (contributions and earnings) and can be obtained tax-free if certain requirements are met.
Dividing an IRA in Divorce
Because the entire purpose of an IRA is to avoid adverse tax consequences, it’s important to be careful when dividing an IRA in divorce. IRAs are considered community property so long as the funds were contributed during the marriage. That means that IRAs are subject to division and distribution upon divorce.
IRAs are not subject to the Employee Retirement Income Savings Act (ERISA), which means that you do not need a Qualified Domestic Relations Order (QDRO) to get the plan administrator to distribute the fund assets to someone other than the named account-holder. However, in order to avoid any adverse tax consequences (such as the 10% penalty), the transfer must be explicitly ordered either in a divorce decree or in a settlement agreement incorporated into the divorce decree.
The divorce decree or settlement should explicitly instruct the plan administrator to distribute the funds into a new IRA in the name of the other spouse. The spouse receiving the funds must, in turn, set up a new IRA in their own name in order to receive the funds. Upon receiving the decree, the plan administrator will divide the IRA as directed by the court decree and transfer any funds owed to the former spouse into their new IRA. If the transfer is made pursuant to a divorce decree, then the transfer is defined as a transfer incident to divorce, and no tax penalties will be incurred.
It’s important to go through the correct process. Trying to transfer the funds by, for example, having one spouse withdraw the funds and deposit them in a new IRA for the other spouse will trigger the early withdrawal penalties. There’s no reason to pay taxes on the IRA funds at this time.
Alternatively, it might be easier to let the account-holding spouse keep their IRA and agree in the settlement for the other spouse to receive the equivalent value in other community assets. That method avoids all the hassle of dividing the retirement account and the risk of unnecessary taxation.
If you’re going through a divorce in Texas and want experienced, effective legal help in evaluating assets, securing a favorable asset distribution, determining alimony and child support, resolving a custody dispute, or reaching a divorce settlement, contact the Houston offices of family law attorney Maria S. Lowry for a consultation on your case.