As a Texas divorce lawyer, I have written about dividing employer-sponsored retirement plans in a divorce through a qualified domestic relations order, or QDRO. These benefit plans are not the only retirement assets to divide in a Texas divorce. Individual Retirement Accounts, or IRAs, are also divisible in a divorce. A key misconception by many suffering through a divorce and some family law attorneys including dividing an IRA in a divorce like an employer-sponsored retirement plan. That is incorrect. An IRA and an employer’s retirement plan like a 401k or defined benefit pension follow different rules in a divorce in Texas.
Today’s post will discuss how an IRA is treated in a divorce, how it is divided differently from an employer’s benefit plan and key considerations when dealing with IRAs in divorces.
What is an IRA
First, let’s talk briefly about what an IRA is. An IRA is an individually-owned tax-advantaged retirement account created under the Internal Revenue Code. The intent behind IRAs was to create accounts that would incentive retirement saving with reasonable investment opportunities. To give effect to this intent, Congress permits IRAs to grow tax-deferred. That means the interest, capital gains, dividends and other income are not taxable at the time received by the account owner like a normal account. Instead, the owner suffers taxation at ordinary income tax rates at the time the funds leave the IRA.
Allowing money to continue to generate earnings rather than paid as taxes through the owner’s life should produce more savings for the owner than if that person invested in a normal account and paid taxes through his or her lifetime. In exchange for this tax benefit, the Internal Revenue Code penalizes IRA owners for taking early withdrawals before the stated retirement age (59 1/2 years of age) unless it meets a few exceptions. That penalty is 10% in addition to the ordinary income tax.
To protect the account owner from excessively speculative investments, Congress also prohibits the ownership of certain types of investments. These generally include insurance, collectables, derivative investments and real estate. (There are quirky ways to get around these rules but that is a different discussion altogether.) IRAs typically invest in stocks, bonds, mutual funds and bank securities like CDs.
Types of IRA accounts
There are different types of IRAs. The most common type is the traditional (or pre-tax) IRA, which allows the account owner to contribute a limited amount of funds each year and take a tax deduction. The contributions plus earnings are taxable when distributed from the IRA. There are also after-tax IRAs in which the contributions are not tax-deductible. Only the earnings will be taxable.
The newest type of IRA are Roth IRAs in which the contributions are not tax deductible; but if future distributions meet certain qualifications then the earnings come out tax free. Traditional and Roth IRAs have income limits for contributions so high income earners often can only contribute to after-tax IRAs. IRAs include rollover IRAs or conduit IRAs funded with rollovers from an employer’s qualified retirement plan. These IRAs may be traditional, after-tax, or Roth.
For divorce purposes a key issue is that IRA ownership is individual. There is no joint ownership in an IRA. The IRS permits married couples to put both spouses’ IRA contributions in a single year in one spouse’s IRA (in certain circumstances). That is important in a divorce because it requires special action by the parties to transfer an IRA from one individual to another. The IRS does not permit individuals to freely transfer a tax benefit from one person to another. However, the Internal Revenue Code provides a method to make this transfer. Let’s talk about that process.
Process to Divide an IRA in a Texas Divorce
Dividing an IRA in a divorce requires following the process laid out in the Internal Revenue Code for IRAs. Any other approach risks either failure to properly divide the account or create unnecessary tax implications for the IRA holder. The correct approach will provide a simple process for the account holder that will smoothly divide the IRA and avoid tax consequences to the account holder. Let’s first discuss the correct approach and then why three other common approaches are wrong.
The Internal Revenue Code (section 408, to be exact) explains that an IRA can be divided in a divorce in one of two ways: a court order related to a divorce (such as a divorce decree) or an agreement incidental to a divorce. Simply put, the divorce decree or a settlement agreement incorporated in the divorce decree needs to include an order to divide the IRA and how to divide the IRA. The language used in the divorce decree or the settlement agreement should clearly state the account holder, the name of the financial institution and precise instructions for how to divide the account, including dollar amounts and/or specific investments.
The IRA custodian (the financial institution holding the IRA on the owner’s behalf) may have forms it requires to facilitate the division but it must have the divorce decree or settlement agreement with the required language. This process is fairly simple (normally). It does not require a QDRO or other unusual process. This approach will divide the IRA in a direct transfer that avoids creating a taxable distribution to the account owner, who will almost certainly suffer ordinary tax and likely will owe the early withdrawal penalty as well. It also allows the recipient of the divided funds to maintain the tax advantages of an IRA.
Is a QDRO necessary for an IRA in a Texas divorce?
Often parties to a divorce and a concerning number of family law attorneys believe one needs a QDRO to divide an IRA. A QDRO is unnecessary and it often cannot divide an IRA. A qualified domestic relations order, or QDRO, is a specific type of order used to divide an employer-sponsored retirement plan that meets the qualification provisions of the Employee Retirement Income Security Act, or ERISA. ERISA provides more stringent protections on retirement assets and among those protections are anti-alienation rules that prohibit any party but the account owner from taking away the owner’s retirement assets. That includes state courts.
The exception to the anti-alienation provisions is a QDRO, a specific type of order carved out by ERISA to divide a qualified plan benefit for limited family law purposes, including the property division in a divorce. QDROs require specific language that cites to ERISA provisions that do not apply to IRAs. Some IRA custodians will accept a QDRO referring to an IRA but not all will. Often the custodian rejects a QDRO because the formula that a pension or 401k needs is not appropriate for an IRA. So preparing a QDRO includes a lot of time and money wasted for no reason. The exception here is a SEP-IRA, which is a form of employer benefit plan, which requires a QDRO.
Another incorrect method of dividing IRAs is where the divorce decree specifies the division appropriately but rather than sending the decree to the IRA custodian and asking the custodian to divide the account, the owner takes a distribution in the ordered amount. This approach might divide the account but it comes at the expense of the tax hit to the account owner and the recipient of the division loses out on the tax benefits of keeping the money in an IRA. There is rarely a good reason to take this approach. It creates a tax liability where none need exist.
A less common but also incorrect approach is when a settlement agreement in a divorce includes the language to divide an IRA and the parties submit the settlement agreement to the IRA custodian for division before the divorce has been granted by the court. There are limited circumstances where this approach makes sense; but there are a number of risks for the account owner in taking this approach. If you consider this approach then you really need to talk to a lawyer about the situation before making decisions to send the agreement to the IRA custodian.
Key Considerations in Dividing an IRA in a Texas Divorce
In addition to the tax implications of an incorrect IRA division, there are several other considerations in how to divide an IRA in a divorce:
- The larger picture. Consider how the IRA funds play into the larger property division. Other assets more easily divided? Or other assets that are more/less valuable to either side?
- Other retirement assets. Are other retirement assets available for division? If so, does it make more sense to divide the IRA? For example, if the recipient is not investment-savvy then dividing an annuity or pension benefit might make more sense. Also, if both spouses have retirement assets it may make sense to divide as few of accounts as necessary.
- The tax benefits. IRAs come with significant tax benefits. When dividing an IRA one party is losing a tax benefit and the other is gaining it. The value of that tax benefit is worth consideration by both parties.
- The tax consequences. On the other hand, if the recipient of the division needs to cash out divided IRA funds to finance getting on their feet after the divorce then eating the income tax and penalty may be detrimental. Taking part of the IRA instead of after-tax funds may not be the best option.
- The liquidity of investments in the IRA. Sometimes IRA investments are illiquid, meaning they are not easily sold into the market. If the IRA investments are illiquid then the value to the recipient may be far less than appraised value. (Especially if the recipient wants to cash out the IRA.) That is because the recipient is stuck with the investments in the account.
- The ability to value the investments in the IRA. Illiquid investments and atypical investments can be difficult to fairly value. That can make dividing the account fairly more difficult. Failing to obtain accurate valuation on the investments can result in an unfair division of the IRA.
- How to divide an IRA. IRAs often divide on a percentage basis; spouses can agree to specific instructions dividing the investments. Who gets what is a tactical decision about exposure, risk, savings goals, investment expertise, anticipated returns and so forth.