Who Pays the Taxes When Early Annuity Distribution Is Part of a Divorce Settlement?

By Rob Jennings J.D.

The spouse who receives the early distribution of an annuity in a divorce settlement is responsible for paying the taxes and any penalties. There are, however, ways to transfer the asset that avoids tax penalties. Also, the divorcing couple can consider the tax implications when negotiating their divorce settlement.

Early Distribution

Annuities are insurance products that pay income. They are often used as part of retirement. The Internal Revenue Service imposes a tax on certain early distributions of annuity funds. Most distributions that you receive from retirement plans and annuity contracts before age 59 1/2 are taxed an additional 10 percent. You pay taxes on the part of the distribution that you must include in gross income. It does not apply to the part of a distribution that is tax free. For example, you would not be taxed additionally on amounts that represent a return of your investment principal or funds that were rolled over to another retirement plan.

QDRO

A QDRO, which stands for "qualified domestic relations order," is a judgment that is issued under state law. In order to be a qualified domestic relations order, the order must contain certain information, such as the amount or percentage of the benefit to be paid and the number of payments. It also cannot change the amount or the benefits of the plan. The QDRO recognizes the existence of a former spouse's right to receive all or a portion of the benefits payable to a participant under a retirement plan. You may be able to roll over all or part of the distribution into a traditional IRA.

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Transfers

If an interest in a traditional Individual Retirement Account is transferred from your spouse or former spouse to you by divorce, the interest in the IRA, starting from the date of the transfer, is treated as your IRA. The transfer is tax free. The two ways usually used to transfer IRA assets to a spouse or former spouse is to change the name on the IRA and to make a direct transfer of the IRA assets. However, if there is a tax, the tax rules that apply to the former spouse who participated in the plan will apply to the other spouse as though she were the actual participant under the QDRO.

Negotiating

As with many divorce terms, a divorcing couple can negotiate the terms of an annuity transfer or early distribution. Therefore, it does not have to be that just one spouse pays all of the tax. The tax may be taken into account regarding the overall settlement. However, the IRS is not held to any agreement that you and your spouse make.

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How to Avoid IRA Early Withdrawal Penalties in a Divorce
 

References

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