In divorce, retirement is at risk

Splitting a retirement plan in divorce often means tax problems. While matrimonial attorneys usually assist in the division of assets, 401(k)s, IRAs and other retirement plans require special handling since eventual distributions generally will be taxable. Unlike most other assets, retirement funds received are not worth face value once taxes are considered. That comes as a surprise when the tax planning is neglected or is not properly explained during the divorce negotiations. The tax details can easily fall through the cracks without proper professional guidance.

In a recent case, the Tax Court ruled that a distribution an ex-wife received from her former husband’s 401(k) plan due to divorce was fully taxable to her, finding that money he owed her did not create tax-free basis.

Gina Weaver-Adams was married to Michael Adams, and during their marriage Michael participated in his employer’s 401(k) plan. They divorced in 2009, and as part of the divorce Gina was named as the alternate payee of Michaels’ 401(k) plan pursuant to a qualified domestic relations order. The QDRO stated that Gina, as alternate payee, was liable for any income taxes on the 401(k) funds she received.

She received a QDRO distribution of more than $103,000 and did not roll over any of the distribution to an IRA or other plan. She received a Form 1099-R from the plan custodian and reported the gross distribution on her federal income tax return for 2009 but claimed that all of it was non-taxable. She took the position that the QDRO distribution was tax-free because Michael owed her money that exceeded the amount of the distribution and, as a result, this created basis (after-tax funds) in her ex-husband’s 401(k).

The IRS sent her a deficiency notice for the unpaid taxes on the QDRO distribution and assessed the 20% accuracy-related penalty for substantial underpayment of income taxes. She disagreed, and the issue went to the Tax Court.

DISTRIBUTION BASICS

When an ex-spouse receives a QDRO distribution as an alternate payee, the Tax Code says that the distribution is taxable to the alternate payee. The ex-spouse can avoid income taxes by rolling over the distribution to an IRA. In this case, none of the funds was rolled over.

The Tax Court rejected her argument that the money her husband owed her created basis in the 401(k) plan. Thus, the entire amount of the distribution was taxable to her.

Generally, when property is transferred incident to divorce, any basis in that property is transferred to the receiving spouse. But the court found that her ex-husband had no basis in his 401(k) plan because only pre-tax funds were in the plan (i.e., pre-tax salary deferrals and employer matching contributions).

The court ruled that she could not escape taxation because she believed that her ex-husband’s debt to her would offset the taxable amount (by creating basis). The debt he owed her was irrelevant. Note: If there had been after-tax funds in his 401(k) (e.g., after-tax salary deferrals or Roth 401(k) deferrals), then she would have received that basis in the QDRO distribution. Gina was not subject to the 10% early distribution penalty because she received the distribution through the QDRO, an exception to the penalty.

The court also noted that there are some circumstances when a QDRO distribution is taxable to the 401(k) participant and not the alternate payee when the distribution discharges a legal obligation, for example, unpaid child support. But that wasn’t the case here. Gina received her interest in the 401(k) as part of a property settlement with her ex-husband.

PENALTY UPHELD

The IRS assessment of the 20% accuracy-related penalty for substantial underpayment of income taxes was upheld. She tried to claim an exception to the penalty for reasonable cause because she relied on the advice of her tax professional. However, she had no proof that a tax professional told her that the distribution was tax-free.

If Gina’s ex-husband gave her the 401(k) to satisfy a debt, taxes should have been taken into account. If that would not have been enough to cover the debt, then the settlement should have dealt with that, perhaps with other assets, if available. The taxes should not have been a surprise. By the time the tax issue was realized, it was too late to change the settlement.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.