Taxation of Retirement Plan Distributions Due to Divorce

Divorce is one of a handful of commonly encountered situations that affect retirement planning. Transfers of interests in retirement plans usually fall under the general nonrecognition rules governing transfers of property between spouses and former spouses. Therefore, when it comes to divorce and retirement planning, a transfer of your interest in a retirement plan should, in itself, be a nontaxable event.

Warning The nonrecognition provisions may be overridden by the assignment of income doctrine, a consideration you should be aware of when planning your settlement. The assignment of income doctrine is a judicially created doctrine that seeks to tax income to the person who earned it, not to the person who may receive it. Under this rule, you cannot avoid tax by transferring your right to receive income to another person while retaining that which generates the income. For example, you cannot avoid taxation upon your wages by assigning your right to receive the wages to a family member in a lower tax bracket. To help ensure that any assignment achieves nonrecognition, you should take all possible steps to transfer the underlying property to your spouse. Further, it would be wise to include a "reimbursement of tax" provision in your settlement agreement, under which your spouse would agree to reimburse you for any taxes resulting from the operation of the assignment of income doctrine.

If you are an alternate payee (i.e., the ex-spouse that does not participate in a retirement plan, but is receiving distributions from it after a divorce), you will be taxed on the transferred retirement benefits once you begin to receive them. Benefits that are taxed as an annuity will be taxed as an employee annuity under the annuity rules. Under these rules, you will be permitted to exclude a percentage of each payment from taxable income based upon the investment in the contract. As an alternate payee, you take over your former spouse's investment in the contract. Generally, a plan participant's investment in the contract is equal to the sum of three components:

• all nondeductible contributions that the participant ever made to the plan (not including contributions used to provide other benefits, such as accident benefits)
• all employer contributions that were includible in the participant's income when made
• all employer contributions to the plan that would not have been included in the participant's gross income had they been paid directly to him or her at the time of contribution

Thus, if all the benefits paid under the plan are attributable to nontaxable employer contributions, the participant's investment in the contract would be zero and you, as an alternate payee, would not be permitted to exclude any portion of the payments from your income. If only a portion of the benefits are awarded to an alternate payee, then the investment in the contract will be apportioned between all those entitled to receive benefits from the plan, in proportion to the respective shares of the entire retirement benefit.

If you are an alternate payee and receive a distribution from a retirement plan, you generally have the option of avoiding current taxation on the distribution by rolling it (or any portion of it) over to an IRA or another qualified plan. The alternate payee generally has the same rollover options that are available to the employee. The portion of a distribution that is rolled over is not taxed until it is finally distributed from the IRA or qualified plan. Any portion that is not rolled over will be taxed as ordinary income in the year of distribution.

In addition, consider the tax treatment involved with transferring these assets in a divorce setting:

• Tax implications of IRAs and divorce
• Tax implications of nonqualified plans and divorce

Alimony. Divorcing taxpayers may use all or part of their retirement benefits to pay their alimony obligations. The person making the alimony payments is not taxed on the distributions, while the recipient is generally taxed in full on the amounts received.

Child support. If retirement benefits are considered child support or used to satisfy this obligation, those benefits are taxable to the plan participant. In such a case, the tax burden cannot be shifted either to the child or the other spouse. In keeping with this rule, child support payments made to the child's other parent are treated as payments made to or for the child.