How to Avoid IRA Early Withdrawal Penalties in a Divorce

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The Internal Revenue Service usually assesses a 10 percent penalty on early withdrawals -- distributions made before you've reached age 59 1/2 -- from a traditional IRA, although several exceptions exist. An exception is available for withdrawals ordered by a court as part of a divorce settlement.

The 10 Percent Penalty

Traditional IRAs provide tax deductions for the money you contribute and defer taxes on the growth of those contributions until IRA money is withdrawn, at which time the withdrawn amount is included in your annual taxable income.

Tip

  • The IRS 10 percent early withdrawal penalty encourages IRA owners to keep their money in the account until retirement age, but the rules carve out exceptions for expense items such as disabilities, building your first home and large medical bills.

Qualified Domestic Relations Order (QDRO)

A judge may decree a QDRO as the result of a divorce or similar court proceeding. A QDRO specifies payments that a spouse must make to the other spouse and/or other relatives -- collectively known as alternate payees -- in the form of alimony, child support and division of assets, among others. Depending on state laws, an alternate payee may be awarded some or all of the assets in your IRA. IRA transfers under a QDRO are not subject to the 10 percent early withdrawal penalty.

Divorce-Related IRA Transfers

Three methods are available for the tax-free transfer of IRA assets in a divorce under a QDRO:

  1. Name Change: If
    your spouse or ex-spouse is to receive the entire contents of your IRA, you can
    instruct your IRA custodian/trustee to replace your name with that of your
    spouse on the account.
  2. Direct Transfer: You
    can arrange a trustee-to-trustee transfer of all or part of your IRA assets to
    your spouse's new or existing IRA.
  3. Combination: If
    you are allowed to keep some of the assets in your IRA, you can transfer those
    assets to another IRA that you own and have the original IRA re-titled in your
    spouse's name.

Tax Consequences

Only the IRA assets transferred to another IRA are moved tax-free. If your spouse takes some or all of the money as a lump-sum distribution, that amount must be rolled over within 60 days into an IRA, or else must be included in the spouse's annual taxable income. In any event, the amount will not be slapped with the 10 percent penalty. You and your spouse will have to fill out IRS Form 8606 to report any changes to your IRA balances resulting from a QDRO and include the form when you file your next tax return.

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