Penalties for Early IRA Wirthdrawals
If a transfer due to a divorce is not done correctly, the amount of the transfer could be considered a taxable distribution.Distributions of previously untaxed amounts from IRAs are taxed as ordinary income in the year in which they are received. In addition, if the taxpayer is under 59 1/2 years old, the distribution is subject to a 10 percent penalty tax on early distributions. The entire tax burden for this falls on the taxpayer taking the distribution. In addition, if an ex-spouse receives money through a nonqualified transfer, the ex-spouse cannot roll it into her IRA, because it is not an eligible rollover.
Required Court Order
To avoid taxation,the agreement to transfer a portion of an IRA to an ex-spouse must be done according to Section 71(b)(2)(A) divorce or separation instrument of the Internal Revenue Code. This means the spouses must include the order to transfer the IRA in a decree of divorce or separate maintenance, or a written instrument incident to such a decree. For example, a simple verbal agreement between spouses getting a divorce would not qualify.
Methods of Transfering an Interest in an IRA
The IRS allows two methods to transfer an interest in an IRA between ex-spouses. First, the financial institution can change the name on the IRA from the owner of the IRA to the name of the ex-spouse. However, this applies only if all the assets in the IRA are being transferred to the ex-spouse. If only a portion of the IRA is being transferred, the IRA money can be moved through a direct transfer from the IRA owned by one spouse to the IRA owned by the other spouse. A direct transfer occurs when the financial institution moves the money straight from one IRA to the other without either spouse receiving cash. A rollover, which occurs when money is paid out to the IRA owner and then redeposited in another IRA, is not a permissible method in the case of divorce.
Do not take a distribution from your IRA and then give the proceeds to your ex-spouse. In Jones v. Commissioner, the Tax Court has held that this is not a valid way to transfer an IRA interest due to divorce. The Court held that the taxpayer was not transferring an interest in an IRA, because the taxpayer had taken the money out of the IRA. Since the taxpayer was simply transferring cash to the ex-spouse, the court refused to treat it as a transfer due to divorce. Therefore, the attempted transfer was considered a taxable distribution and was subject to taxes and the additional 10 percent tax.