Splitting An IRA With Ongoing 72(t) Distributions In Divorce
Although the aggregate divorce rate amongst Americans has fallen in recent decades, there has also been a concurrent (and dramatic) increase in the number of divorces for couples over age 50. The rise of the so-called “grey divorce” has created a number of uncommon and complex issues that financial advisors are helping their clients navigate, such as splitting what can oftentimes be substantial assets, including retirement accounts. Splitting an IRA, for instance, is generally pretty straightforward, but the matter becomes far more complicated for accounts that have ongoing 72(t) distributions.
As a starting point, it’s important to understand what a 72(t) distribution is in the first place. Although IRA accounts are intended to provide retirement funds for the owner, there can be emergent situations in one’s life for which an individual might not have the necessary cash on hand. Understanding that, Congress provided for a handful of exceptions that allow an individual to access the funds in their IRA accounts prior to age 59 ½ without triggering the dreaded 10% early withdrawal penalty. One of these exceptions includes the option to elect taking “substantially equal periodic payments” from the IRA, also known as 72(t) payments.
Although there are a few IRS-approved methods to calculate the exact amount of those substantially equal periodic payments, the key component is that the individual must continue to take those distributions “without modification” for the longer of five years, or until age 59 ½. Modifications can include (among other things) changing the amount of the periodic withdrawals (other than as allowed via the RMD method), taking an additional distribution on top of the 72(t) payments, changing the balance on the IRA account via roll-ins or rollovers out of assets, or making a non-taxable transfer of a portion of the account balance. And it’s that “non-taxable transfer” rule that can cause so much confusion for divorcing couples who need to split an IRA that is subject to 72(t) distributions.
Under normal circumstances, splitting an IRA that is not subject to a 72(t) distribution schedule between a divorcing couple is simply a matter of the custodian transferring the funds specified by the divorce decree from the current owner to a (new) IRA account in the name of the ex-spouse. However, since dividing an IRA pursuant to a divorce decree is, in fact, a non-taxable transfer, it seems possible that the IRS would deem that transfer to be a “modification” for IRAs subject to 72(t) payments, thus triggering the 10% penalty… plus interest!
Fortunately, though, over the years, the IRS has issued several Private Letter Rulings (PLRs) addressing this very conundrum. These PLRs have been rather accommodating to both ex-spouses. Transferor ex-spouses have been given the option to decrease future 72(t) distributions proportionally to the amount that was transferred out of the account. Meanwhile, transferee ex-spouses have not been required to continue to take 72(t) distributions, though they have been allowed to choose to do so if desired!
Ultimately, the key point is that, while divorce is a stressful event that often creates unforeseen financial hurdles for advisors and their clients to navigate the best they can (and sometimes without any formal guidance from the IRS on unclear taxation rules), there has at least been consistency (albeit on a case-by-case basis) in the rulings around the treatment of transferring the balance of an IRA that’s subject to 72(t) payments in a divorce.