Taxation of IRA Distributions Incident to Divorce

When it comes to divorce and retirement planning, the transfer of an individual retirement account (IRA) to a spouse or former spouse under a divorce or separation instrument is typically a nontaxable transaction for both parties. Following the transfer, the IRA is treated as an IRA of the transferee spouse or former spouse.

The following are all IRS-approved ways that can be used in any combination to make a transfer of IRA assets between divorcing or separating spouses:

• Name change. When transferring all the assets of an IRA account, the transfer can be accomplished simply by having the trustee change the name on the IRA from that of one spouse to the other.
• Direct transfer. The IRA owner makes a trustee-to-trustee transfer of assets (all or partial) to the other spouse's IRA.
• Rollover. The IRA owner withdraws the amount of IRA funds being transferred to the other spouse and deposits them in the other spouse's IRA account, or transfers the funds to the other spouse, who then must deposit the funds in an IRA within 60 days of the date that they were withdrawn from the IRA.

Tip Alimony payments can be used by the receiving spouse to fund a traditional tax-deductible IRA up to the annual limit and other limitations. This can offer some planning opportunities when structuring the divorce settlement. For example, the higher earning spouse can offer to pay an amount equal to the IRA contribution limit as alimony, thereby reducing his taxable income. At the same time, the receiving spouse will essentially not have to pay tax on the alimony received, since it is going into a tax-deductible IRA.