How to help divorcing couples make a tax-free IRA transfer
Divorces are often messy, as was the case for Michigan doctor John Kirkpatrick. Dr. Kirkpatrick separated from his wife, Christiana, in 2012, but six years later, found himself in Tax Court after he failed to pay taxes on $140,000 in IRA distributions he withdrew to transfer to his ex.
Recently, in his case, the Tax Court reminded us that there are only two ways to make a tax-free transfer of IRA assets in a divorce proceeding.
One way is to simply change the name of the IRA to the ex-spouse. The other way is to directly transfer IRA assets to an IRA owned by the ex-spouse.
What you cannot do, however, is take a distribution from the IRA and transfer those funds to a checking account. That mistake is what ended up costing Dr. Kirkpatrick.
The case is an important reminder that after a divorce decree is carefully reviewed, advisors need to assist clients in transferring IRA funds to comply with the divorce decree’s terms.
The decree should be specific about how and when assets are split. If the IRA is invested in assets that fluctuate in value, the date that the IRA is divided may be critical. The divorce decree also should clearly state who is responsible for any fees and how they are paid.
If a divorce decree is unclear on any of these matters, an advisor may consider asking the court for more clarification. In rare circumstances, a divorce decree may need to be revised. Finally, don’t assume that your client’s divorce attorney is well versed in how IRAs should be handled in a divorce. This is a very specialized area, and mistakes are costly and often unfixable.
To get the ball rolling, the advisor or IRA owner should provide a copy of the divorce decree to the IRA custodian. Without this, the IRA custodian has no authority to move the IRA funds, so the custodian will want to see this document before proceeding with any transactions.
The IRA owner should then complete paperwork with the IRA custodian, authorizing a direct transfer of the IRA or the portion of it awarded to the ex-spouse. Because the account belongs to the IRA owner, the authorization must come from him to move the funds.
Also, the IRA owner is the one subject to the court order. If the ex-spouse already has her own IRA, the funds may be transferred to that account. If the ex-spouse does not have an IRA, then she will need to complete the necessary paperwork to establish one in order to receive the IRA funds awarded under the divorce decree.
The IRA custodian will then move the funds from the IRA to the ex-spouse’s IRA. This transaction is accomplished by a trustee-to-trustee transfer, in which the funds will move directly from one spouse’s IRA to the other spouse’s IRA. There is no reporting issued to the IRS. Forms 1099-R and 5498 are not required because the transaction is handled as a transfer and not as a distribution and subsequent rollover. There are no tax consequences to the IRA owner or the ex-spouse due to the transfer of the IRA.
What not to do: In 2012, Dr. John Kirkpatrick and his wife Christiana were going through a contentious divorce. They were fighting bitterly over custody and visitation for their children, spousal support and the division of assets. Near the end of that year, they reached an agreement on some of the issues. In that consent decree, Dr. Kirkpatrick was to transfer $100,000 from his IRA to an IRA for Christiana, and to pay her $40,000 in attorney fees. The divorce was eventually finalized in 2014.
The divorce order specifically stated that the $100,000 IRA transfer to Christiana should be done “directly” and “in a non-taxable transaction” into “an IRA appropriately titled in Ms. Kirkpatrick's name.” But that was not done.
Instead, Dr. Kirkpatrick made two withdrawals from his IRA during that year. The funds were deposited into his checking account and he made a series of payments to his ex-wife and third parties to satisfy the $140,000 order. The couple filed a joint return for 2013 and excluded the $140,000 from their taxable income. They believed that the withdrawals were transfers due to a divorce and were therefore non-taxable.
The IRS disagreed and issued a notice of delinquency. Thus, the question before the Tax Court was whether Dr. Kirkpatrick completed a tax-free transfer of his IRA by taking the distributions and directly paying his ex-spouse and some of her creditors.
The court’s decision: The IRS won. The court held that the IRA withdrawals were not tax-free transfers due to a divorce. Instead, they were regular distributions, subject to income taxes.
Dr. Kirkpatrick believed that the exception applied to any IRA distribution that was transferred to an ex-spouse if it was required by the divorce court and completed before the divorce was finalized. Moreover, he argued that even though the funds passed through a checking account, it should have no bearing since the money was ultimately transferred out of the account and to the ex-spouse before the divorce was final. Finally, he argued that the number of transfers and the method of transfer should have no bearing on the tax status of a transferred IRA distribution.
The court first dismissed the argument related to the $40,000 in attorney fees. Nothing in the original consent decree required the debt to be paid with IRA assets. For the exception to apply, the divorce court must specifically order a transfer of IRA assets. These expenses could have been paid from any asset source — retirement plan or not.
Second, the court rejected Dr. Kirkpatrick’s argument that taking an actual distribution had no impact on its taxable status. The Tax Court pointed out that it had previously ruled that the IRA exception does not apply to proceeds from an IRA cashed out and paid or transferred to an ex-spouse following a divorce decree.
In citing the case of Bunney v. Commissioner, 114 T.C. 259, April 10, 2000, the court described the two common methods of executing a tax-free IRA transfer due to a divorce: 1) retitling the IRA to the other spouse or 2) directly transferring funds from one spouse’s IRA to another.
From the court: “In Bunney we rejected the idea that taking a distribution from an IRA and then making a payment to one’s spouse qualifies as a transfer of an interest in that IRA. “
Here, all relevant sources – the Code; the caselaw; Internal Revenue Service guidance...; and even the consent order in petitioner’s divorce proceedings – suggest that taking distributions from IRAs and writing checks to one’s spouse is not the appropriate form for a tax-free transfer of an account incident to divorce under section 408(d)(6).”
Dr. Kirkpatrick lost his case and ended up with the tax bill even though his wife got the money.
This could have been avoided if he had only followed the judge’s advice in the earlier state court order and done a tax-free transfer. His ex-wife lost out too! She did not get funds eligible to be in an IRA. No advisor would want their client to end up with this bad of an outcome.
Timing and limits: It’s hard to understand where the Kirkpatricks came up with the funky timeframe for qualifying for the exception. The truth is, there is no timeframe. As long as the transfer is done in line with a divorce decree and by one of the methods stated above, it will be a tax-free transfer. That means it can occur before or after the divorce is finalized. Moreover, there are no limits on the number of transfers. Again, it just needs to be pursuant to the decree or order. Thus, a Court could order two tax-free IRA transfers to occur in separate years.
While some laws are unclear, and have gray areas, that is not the case here. The Tax Court has routinely held that taking an IRA distribution and then transferring those funds to an ex-spouse does not qualify as a tax-free transfer due to a divorce.
Divorces are already painful enough. Don’t make it worse for clients by ignoring well-established tax law.