Generally speaking, the division of property, including cash, between couples going through divorce has no immediate federal income or gift tax consequences. Such transfers are considered tax-free gifts between the spouses. However, the tax-free transfer rule doesn’t apply to balances in an IRA transfer. If an IRA owner withdraws funds from his or her IRA and gives it to his or her spouse (or anyone else for that matter), the withdrawal is taxable to the IRA owner and tax-free to the receiving spouse (or whoever receives the distribution).
Fortunately, there’s an important exception to this rule. If an individual’s interest in an IRA completes an IRA transfer to a spouse or former spouse pursuant to a divorce decree or separate maintenance agreement isn’t taxable to either spouse. This spousal exception for transfers incident to divorce applies to Roth IRAs, SEP accounts, and SIMPLE IRAs as they’re all considered IRAs for this purpose (however, it’s important to note that qualified retirement plans require a Qualified Domestic Relations Order (QDRO) and follow different rules).
It’s important to note that the exception applies to spouses only. A distribution or transfer to anyone other than a spouse or former spouse, even if pursuant to a divorce, is generally taxable to the IRA owner.
The IRA transfer is tax-free to both spouses only if the transfer is specifically required by a decree of divorce or separate maintenance agreement (or a written instrument incident to such a decree). In other words, the couple must eventually divorce or legally separate. Completing an IRA transfer under any other type of order, such as a temporary alimony or support order, is not tax-free.
Here’s an example of how this might work in practice. In connection with his pending divorce, Bill has agreed to transfer his IRA to his spouse, Andrea. The transfer to Andrea must be made pursuant to their divorce decree (or a written instrument incident to the divorce); otherwise, it will be taxed to Bill. Also, a transfer made to anyone other than Andrea, such as to their children, will be taxable to Bill. If the transfer is taxable to Bill, he must include that amount in taxable income. Furthermore, if Bill is under age 59½, the 10% penalty tax on premature distributions may also apply.
An IRA interest transferred under a decree of divorce or separate maintenance agreement is thereafter treated as the recipient spouse’s IRA for all purposes. Therefore, the recipient spouse can manage the transferred money as he or she sees fit and continue deferring taxes until withdrawals are taken from the IRA. At that point, the recipient spouse will owe any federal income tax on the withdrawal. In addition, at that point the 10% penalty tax on premature distributions may apply if he or she is under age 59½ at the time of the withdrawal.
The safest way to accomplish a divorce-related IRA transfer is through a trustee-to-trustee transfer. If the IRA trustee will not make a payment to the spouse’s or ex-spouse’s IRA, the transferor spouse can roll over the funds to a new IRA in his or her name and then assign ownership (and change the name) of the new IRA to the receiving spouse.