Divorce is a major life event that can have significant personal and financial consequences. In addition to addressing family and emotional concerns, you’ll need to determine whether your assets are divided equitably. When assessing the fairness of a divorce settlement, taxes are a critical consideration. In general, you can divide most assets between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. (See “How the Tax-Free Transfer Rule Works” below.)

However, special rules apply to transfers of retirement account assets between divorcing spouses. A properly structured divorce agreement can help you avoid potential pitfalls related to these tax-advantaged accounts.

IRA Transfers

Federal income tax rules allow divorcing spouses to divvy up IRAs without adverse tax consequences. The following types of accounts are considered IRAs for this purpose:

• Traditional and Roth IRAs,
• Simplified Employee Pension (SEP) IRAs, and
• Savings Incentive Match Plans for Employees (SIMPLE) IRAs.

Essentially, you can arrange for a tax-free transfer of all or part of your interest in an IRA to an IRA maintained in your ex-spouse’s name. The IRA custodian generally completes this transaction by transferring the assets directly or changing the name on the account. After the transfer, the recipient spouse generally is responsible for taxes on future taxable distributions.

However, there’s an important catch: The transfer must be made under a decree of divorce or separate maintenance or a qualifying written instrument incident to the decree.

If you voluntarily give your ex-spouse some IRA funds before it’s required under a divorce or separation instrument, it will be treated as a taxable distribution to you. That means you’ll owe the related taxes — even though you didn’t actually keep the money. Plus, if you’re under age 59½, you’ll generally owe a 10% penalty on the early distribution, unless an exception applies. For certain distributions from a SIMPLE IRA during the first two years of participation, the additional tax may be 25% rather than 10%.

Transfers from Qualified Retirement Plans   

Dividing benefits under employer-sponsored qualified retirement plans generally requires a qualified domestic relations order (QDRO). A QDRO is commonly used for the following retirement assets:

• Qualified retirement plans at work, such as 401(k) plans,
• Self-employed or small business qualified plans, such as Keogh or corporate profit-sharing plans, and
• Defined benefit pension plans.

Many employer-sponsored plans are prohibited from transferring funds or paying benefits to a former spouse without a valid QDRO on file. A QDRO establishes your ex-spouse’s legal right to receive a designated percentage of your retirement account balance or designated benefit payments from your plan. It ensures that your ex, and not you, will be responsible for the related income taxes when they receive taxable distributions from the plan.

A QDRO also allows your ex to roll over an eligible rollover distribution received under the QDRO tax-free into an IRA (assuming the plan permits such a withdrawal). That way, your ex can take over management of the money while postponing income taxes until taxable withdrawals are taken from the rollover IRA.

Non-QDRO Transfers

Without a valid QDRO, money that’s transferred from your qualified retirement plan account to your ex-spouse is generally treated as a taxable distribution to you. That means your ex will get the money tax-free, and you’ll owe all the taxes and, if you’re under age 59½, the 10% penalty (unless an exception applies).

Additionally, the extra income from a large taxable distribution could potentially push you into a higher tax bracket and may increase the likelihood that your other investment income will be subject to the 3.8% net investment income tax (NIIT). It may also reduce tax breaks subject to income limits.

Tax-Smart Divorce Settlements

If both spouses have their own retirement savings, it might be easier for each spouse to retain their own account and split up other assets to achieve an equitable settlement. If retirement accounts must be divided, it’s essential to address retirement account transfers properly in your divorce agreement and consult your tax advisor before finalizing your settlement.

In general, avoid taking marital assets at face value. Instead, consider their after-tax values. For example, distributions from traditional retirement accounts generally are taxable. Conversely, qualified Roth distributions generally are tax-free because Roth contributions are made with after-tax dollars.

Seek Professional Guidance

Settling the financial aspects of a divorce can be complicated, especially if the parties have been married for many years and have accumulated substantial net worth. Your tax and financial advisors can help you evaluate various settlement options — including asset allocations and support payments — that minimize potential taxes and meet other personal objectives.

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