On January 28, 2014, the United States Tax Court ruled in a memorandum opinion (T.C. Memo. 2014-21) that a married couple must pay a tax penalty after completing more than one IRA rollover transfer in a single year. The Court based its decision on the IRS code’s limitation of tax-free IRA rollovers under 26 U.S. Code Section 408(d)(3)(B). This section defines an IRA rollover as a transaction that involves an individual taking a distribution from his or her IRA/annuity and then reinvesting that same amount of funds within 60 days to an IRA/annuity. According to this Section, an individual can undertake this action one time in a twelve-month period without experiencing any tax consequences.
According to a Virginia Weekly article in June 2014 discussing the Tax Court’s decision, the rationale behind the limitation on IRA rollovers is to prevent taxpayers from repeatedly liquidating their IRAs to access their retirement funds for 60 days at a time, essentially taking a loan for a short period of time from their retirement benefit.
But does this limitation relate to sharing and dividing IRAs incident to a divorce? It shouldn’t, even though lawyers are blogging about how divorced couples can no longer “rollover” multiple IRA pursuant to divorce within a twelve-month period without experiencing tax implications. Upon reading and hearing this dialogue among my colleagues, I instantly questioned the application of this rule to divorce practice. What about our clients with multiple IRAs? Would they be forced to spread out their IRA transfers for many years after divorce?
The good news is that the limitation on IRA rollovers provided under 26 U.S. Code Section 408(d)(3)(B) should not limit IRA transfers incident to a divorce. First, 26 U.S. Code Section 408(d)(6) excludes transfers from an IRA incident to divorce from the taxable income definition 408(d)(1).
Second, parties going through a divorce should not be completing “rollovers” to divide their IRAs incident to divorce. Instead, a “direct trustee to trustee transfer” should divide the IRAs incident to divorce. Footnote 5 of the Tax Court’s memorandum opinion recognized that such direct transfers are not limited in number, stating “Taxpayers who maintain more than one IRA may make multiple direct [transfers] from the trustee of one IRA to the trustee of another IRA without triggering the Section 403(d)(3)(B) limitation.” Transferring funds directly does not place the funds in the control or use of the participant, and therefore are not considered to be “rollover contributions.” Id. citing Rev. Rul. 78-406, 1978-2 C.B. 157. See also, the aforementioned Virginia Weekly article stating, a “trustee-to-trustee” transfer can be done “as often as possible and always tax-free”
When dividing IRAs incident to divorce, a party is not rolling over her IRA, as she is not receiving a distribution or payment from her IRA that is then reinvested on behalf of the other party. To best serve our clients, Divorce Lawyers must characterize the IRA division procedure properly in Settlement Agreements and Divorce Orders to avoid the division being done as a “Rollover.” The language should provide that the IRA transfer is a direct transfer or “trustee-to-trustee direct transfer.” Divorce Lawyers can further add to Settlement Agreements and Final Orders of Divorce that the IRA shall not be divided in any fashion that would create a “Rollover” event pursuant to 26 U.S. Code Section 408(d)(3).