An IRA is an Individual Retirement Account. There are several kinds of IRAs but the two main ones are Traditional IRAs and Roth IRAs. An individual contributes to an IRA on his/her own and not through an employer. In a divorce, you need to decide whether each IRA will:
- remain with the account holder;
- be transferred to the other spouse; or
- be divided somehow.
The maximum that can be contributed to an IRA in tax year 2021 is $6,000 ($7,000 if you are 50 or older). You get to decide for both Traditional IRAs and Roth IRAs how you want the money to be invested. Monthly or quarterly you receive a statement for the account. The statement gives its current value, taking into account all contributions and the investment gains and losses.
Traditional and Roth IRAs are similar to 401(k)s. However, in a divorce, a QDRO is not required to transfer or reassign the monies in an IRA. Check with the financial institution holding the IRA to see what paperwork they require. Usually they will want an “IRA transfer letter” and/or forms to be filled out, plus maybe a copy of the divorce judgment.
Your divorce settlement agreement should be very clear as to who is receiving how much monies from each IRA. If there is to be any transfer of monies from the account holder, specify the amount to be transferred and when the transfer is to occur. In advance of the transfer, the recipient will normally set up a “rollover IRA” into which the monies will be transferred.
Community vs Separate Property
If all the contributions and changes in IRA’s value occurred between the date of marriage and the date of separation, California law considers them to be community property. Contributions that were made before marriage or after the date of separation are considered to be separate property. So is the growth in account value that arose from them.
Sometimes the monies in an IRA are a mixture of separate and community property. Determining an accurate valuation for each requires analyzing all the monthly statements over the life of the account. This is tedious and it may be hard to acquire all the statements. Therefore, couples usually take a simpler approach. This is often based primarily on the value of the account at the date of marriage, at the date of separation and currently.
IRAs and Taxation
If all or part of an IRA is transferred directly to another IRA, neither spouse will owe any taxes on the transfer. However, if one spouse cashes out all or part of the IRA and then transfers the money to the other spouse, the spouse who cashed out will owe taxes on the money withdrawn. It’s therefore crucial to be sure that the money goes directly from one account to another in what’s called a “trustee-to-trustee” transfer or “assignment of ownership.”
If you withdraw money from either a Traditional or Roth IRA before reaching age 59½, you’ll pay a 10% penalty to the IRS unless you meet certain exceptions. These exceptions are discussed briefly below.
When you withdraw money from a Traditional IRA, the amount of money withdrawn is taxed as if it were ordinary income.
When you withdraw money from a Roth IRA, you don’t have to pay any tax on the money withdrawn if you are at least 59½ and the Roth IRA account has existed for at least 5 years. If you are not yet 59½ but the amount withdrawn from the Roth IRA account does not exceed the amount contributed to the account, no tax is due. But if you are not yet 59½ and the amount withdrawn includes both contributions and investment gains, income tax will have to be paid.
It’s therefore generally better tax-wise to hold off withdrawing from an IRA until retirement. So if you need cash as a result of your divorce, it’s usually best to find it somewhere other than in an IRA.
IRA Legal Value
If your divorce ends up in court, the “legal” value the court assigns to an IRA is the amount that appears on a current statement. This could be a lot different from the real financial value. The real value would take into account realities such as taxes and early withdrawal penalties.
Be aware if you are considering bankruptcy that IRAs are fair game for creditors.
IRA Early Withdrawal Penalty Exceptions
Most early withdrawals are subject to the 10% penalty. Here are some possible ways to avoid the early withdrawal penalty. There are a few others that are very uncommon.
- Withdraw the money in “substantially equal periodic payments” (SEPP) in accordance with Section 72(t) of the tax code. There must be at least one withdrawal per year for five years or until you turn 59. The IRS gives you three different ways to determine the “substantially equal” amount.
- Exchange the IRA for an annuity. With an immediate annuity, you give a lump sum of money from the IRA to an insurance company in exchange for a guaranteed regular payment over a specified period of time.
- Withdrawals used to pay high medical expenses or college costs.
- Withdrawals (limited to $10,00 for an individual) for first-time home purchases.
- Withdrawals due to a mental or physical disability.