Getting Divorced? How to avoid tax pitfalls when splitting up retirement accounts

qdro1On top of all the other stuff, getting divorced is also a major financial transaction that can have serious tax implications. This is especially true when it comes to splitting up tax-favored retirement accounts between you and your soon-to-be ex. You need to plan ahead to make sure the tax results turn out OK for you. Recurring litigation between taxpayers and the IRS shows many folks falling into expensive traps that could have been easily avoided. Here’s what you need to know to keep from joining them.

Use QDROs to divide up qualified retirement plan accounts

Say you participate in a qualified retirement plan at work — such as a 401(k) or profit-sharing plan. Or you might be self-employed with a small business retirement plan such as a simplified employee pension plan (SEP), Simple IRA, or solo 401(k) plan. You’ll probably have to divide up your retirement account (or accounts) between you and your ex as part of the divorce property settlement. However, doing it carelessly can create a real tax fiasco for you.

To divide up qualified retirement plan accounts the tax-smart way, you must establish a qualified domestic relations order, or QDRO. What’s a QDRO? It’s simply some boilerplate language that should be included in your divorce papers. First and foremost, the QDRO establishes your ex’s legal right to receive a designated percentage of your retirement account balance or benefit payments from your plan. The good news for you is the QDRO also ensures that your ex, and not you, will be responsible for the related income taxes when he or she receives payouts from the plan.

The QDRO arrangement also permits your ex-spouse to withdraw his or her share of the retirement plan money and roll it over tax-free into an IRA (assuming the plan permits such a withdrawal). That way, your ex can take over management of the money while postponing income taxes until withdrawals are taken from the rollover IRA.

Bottom line: the QDRO is a fair deal for both you and your ex because it ensures that the person who gets retirement plan payouts will also owe the related income taxes. Who can argue with that?

So far so good, but here’s the tax issue. If money from your qualified retirement plan gets into your ex-spouse’s hands without a QDRO being in place, you face a potentially disastrous tax outcome. You’ll be treated as if you received a taxable payout from the plan and then voluntarily turned the money over to your ex. So you’ll owe all the taxes while your ex gets the money tax-free. Even worse, the extra income from a big taxable transfer of retirement account balances could push you into a higher tax bracket, cause some or all of your investment income to be hit with the 3.8% Medicare surtax, cause some or all of your personal and dependent exemption write-offs to be phased out, and cause some of your itemized deductions be phased out. To add further insult to injury, you might also get stung with a 10% penalty tax if this happens before you’ve reached age 59½.

So make sure your divorce papers include the necessary QDRO language. Helpfully enough, the Feds even provide sample language in IRS Notice 97-11 (it can be easily tracked down with an internet search).

The tax rules on retirement plan payouts have been around for many years, so you would think the preceding advice would be so well-known that I wouldn’t have to give it. You would be wrong. There have been tons of court cases where individuals turned over retirement plan money to their ex-spouses without bothering with QDROs, and new cases are still popping up with regularity. The account owners in all these cases wound up getting socked with big tax bills. Not fair to them, but the tax rules are often unfair to folks who don’t know what they are doing.