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Tax traps for divorcing clients

The surprise split of Amazon CEO Jeff Bezos and his wife MacKenzie puts advisors on alert: Are you prepared with appropriate retirement and tax advice if your clients divorce?

It’s unlikely that Bezos will have to crack open his Amazon 401(k) or IRA to get through this event. But for your average client, that’s exactly where most of their wealth may be.

Though you can’t predict which of your clients might divorce, you should know the rules of how large retirement balances are split if the event occurs. Do you know which of your clients live in states where the community property rules may apply, or where ERISA might trump those state laws when company plan funds are involved? It’s worth looking up.

Advisors also need to know how an IRA or 401(k) might be divided. This is one area where the biggest tax mistakes are made. Such errors mean that everyone ends up with less — including you, the financial advisor.

This type of advice is a high-value personal service and can make or break your relationships and future referrals. And, as seen in the harrowing case studies below, failure to cover these bases could seriously impact your clients.

Here are key points to know when splitting up a retirement account in a divorce.

Jeff Bezos and MacKenzie Bezos Jan 10, 2019
FILE: Jeff Bezos, founder and chief executive officer of Amazon.com Inc., and his wife Mackenzie Bezos, arrive at the Robin Hood Foundation’s annual benefit in New York, U.S., on Monday, May 12, 2014. Amazon.com Inc. founder Jeff Bezos, the world’s richest person, and his wife MacKenzie are divorcing after 25 years. Bezos, 54, is worth $137 billion, according to the Bloomberg Billionaires Index, a ranking of the world’s 500 wealthiest people. The couple met when they both worked at hedge fund D.E. Shaw, and they married in 1993. He founded Amazon a year later. Photographer: Peter Foley/Bloomberg

IRAs and 401(k)s

Divorce will impact many retirement plans because they may be among a client’s largest assets. But IRAs and other retirement accounts are unlike most other assets because of the tax rules surrounding distributions from these accounts. Normally, any distribution would trigger a tax bill that would have to be figured into a divorce agreement.

Divorce is one of the few times that retirement assets can be transferred from one individual, during his or her lifetime, to another with no tax consequences. However, tax rules for IRAs and employer plans, including 401(k)s, are very different, when it comes to splitting them up in a divorce.

An employer plan is split using a qualified domestic relations order. This QDRO is a court order that is submitted to the plan administrator for qualification. Once it is qualified, it allows employer plan assets to be retitled and made available to the ex-spouse if the plan allows. Most plans do allow a spouse full access to their separate account under the plan.

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Distributions from the QDRO plan to an ex-spouse will not be subject to the 10% early distribution penalty.

Note: a similar exception is not available for IRAs split in a divorce. When QDRO plan funds are rolled over to an IRA, this exception is lost.

QDROs do not apply to IRAs. IRAs are split according to the divorce or separation agreement, and the transfer must be a direct transfer from one spouse to the other spouse. This will be a tax-free transfer incident to the divorce. However, it’s a big mistake to take a distribution from the IRA and give those funds to the ex-spouse. That would be a taxable distribution to the IRA-owning spouse. This is exactly what happened in the 2018 Kirkpatrick case where the IRA transfer due to the divorce was supposed to be tax-free, but ended up as a taxable distribution costing the couple thousands in unnecessary taxes.

Community property — surprising outcomes

The Bezos divorce brings up another interesting twist: Jeff and MacKenzie Bezos they live in Washington state, one of the nine community property states. The others are: Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, and Wisconsin. Alaska has adopted an optional community property system.

Community property laws can really throw a monkey wrench into who ends up with a retirement account. Take this recent case involving Gwendolyn and Michael Berry (United States v. Gwendolyn Berry; No. 4:17-cr-00385, Released December 17, 2018), where the government took part of Gwendolyn’s community property interest in Michael’s retirement accounts, even though he owed nothing to IRS.

Here, there was no divorce but the couple was separated physically when Gwendolyn went to jail for tax and mail fraud. Here, the government pursued restitution of more than $2.1 million from Gwendolyn due to her criminal financial activity. In order to meet this lofty sum, the government will garnish all of her eligible assets. But since she and her husband live in a community property state, the government also got half of Michael’s eligible assets, including retirement dollars in two IRA accounts, even though he did nothing wrong.

Gwendolyn was a former bookkeeper convicted of embezzling money from a client’s account. She is currently serving fifty-one months in prison for wire fraud, mail fraud, and filing false tax returns. At her sentencing, the judge ordered her to make full restitution to the person from whom she stole. To satisfy this order, the government located five separate IRAs owned by the Berrys and filed garnishment writs on each.

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Three of the accounts were owned by Gwendolyn, so the government sought to garnish 100% from those accounts. The other two were owned by Michael. Even though he was not a party to her criminal activity, the government requested a garnishment order on one-half of each of his accounts.

Michael challenged the garnishment writs, but lost. The problem was that Mr. and Mrs. Berry lived in Texas, which is a community property state. Community property consists of property or assets acquired by either spouse during the marriage. The Fifth Circuit Court of Appeals previously held that restitution liens apply to community property - even property managed by a spouse who is not liable for the debt. The lien is limited to the spouse’s interest, which is one-half. As a result, the government was successful in asserting that since Gwendolyn has a 50% community property interest in her husband’s IRAs, the garnishment writs towards his two IRAs were proper.

While Michael obviously couldn’t have predicted that his wife would become a criminal, there is a lesson here even for your law-abiding clients who live in community property states. Community property is everything a husband and wife own together. In general, this includes all money earned and property acquired during the marriage. For community property rules to apply, a client must have two things; a valid marriage and a domicile in a community property state. Community property rules can determine who gets a retirement plan at death, after a divorce or even when one spouse owes money, as was the case with the Berrys. These are state laws, and often conflict with federal law.

For example in the landmark Boggs case (Boggs v. Boggs, 520 U.S. 833, 1997)

In it, the U.S. Supreme Court ruled that when there are conflicting claims, ERISA trumps community property law. Here, Boggs remarried after his first wife died. When he died, he left his plan benefits to his second wife.

The children from Boggs’ first marriage claimed that part of Boggs’ company retirement plan belonged to them since they inherited a community property interest in those funds from their mother (Boggs’ first wife). They lost and the funds went to the second wife. The court said that ERISA (federal law) trumped community property (state law) and awarded the funds to the second wife who was the named beneficiary of the company plan.

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Another oft-cited case is the Bunney case (Bunney v. Commissioner; 114 T.C. No. 17; No. 20713-97, (April 10, 2000). Here, similar to the Kirkpatrick case cited above, Michael Bunney and his wife divorced and he withdrew funds from his IRA and gave them to his ex-wife as part of the divorce settlement. As in the Kirkpatrick case, this distribution was taxable because he didn’t transfer the funds directly to his ex-wife according to the divorce agreement.

But here, Mr. Bunney claimed that since they lived in a community property state, half of his IRA already belonged to her, so the IRA distribution should not be taxable. He, too, lost when the court ruled that even though spouses are equal owners of an IRA under community property law, the IRA owner pays the tax on a distribution to an ex-spouse. Mr. Bunney had to pay the tax on the IRA distribution that he gave to his ex-wife. If this was done as a direct transfer, there would have been no tax bill.

New rules in 2019

Advisors can check beneficiary forms, which in some cases can override community property interests. Even so, if clients wish to name someone other than their spouse as their IRA beneficiary, they should get a spouse’s written consent, when community property rules apply.

Advisors should also plan ahead now to avoid uncertainty later. Bezos and his wife reportedly did not have prenuptial or postnuptial agreements. Clients can be encouraged to consider these options even if they do not have billions of dollars. Smart advance planning can save money and avoid costly litigation if a divorce occurs.

Finally, remember that now, in 2019, the tax rules for alimony have changed. Alimony on post-2018 divorce agreements is no longer deductible for the payer and no longer taxable the spouse-recipient. This is yet another item to add to the tax complications of divorce.

While you don’t have any clients with the wealth of Jeff Bezos, you do have clients with their own thorny issues and they will need to salvage every dollar. Hopefully you can help them avoid the tax traps of splitting retirement accounts in a divorce.

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