Accounts that are part of qualified retirement plans are often a significant bargaining tool for parties trying to negotiate a fair property settlement agreement. These accounts are usually flush with marketable securities, which makes them an enticing source to tap when parties are looking to “true up” unequal divisions of other marital assets. However, if permitted, distributions from these accounts may come with unintended federal (and possibly state) tax consequences if not structured properly.
Generally, Internal Revenue Code (IRC) Section 72(t) imposes a 10% penalty tax on taxable distributions from qualified retirement arrangements (including traditional, Roth, SEP, and SIMPLE IRAs) received before age 59 ½. The 10% penalty is on top of the tax liability incurred because of the inclusion in Adjusted Gross Income (AGI) of the distributed amount. As you can imagine, a divorcing spouse under age 59 ½ in the highest marginal federal tax bracket (currently 39.6%) will be in for an unpleasant surprise on April 15 when he or she realizes that the distribution taken from their retirement plan to settle their divorce is subject to an approximate 50% tax. If aware, perhaps the offer amount would have been a bit different! With proper planning, however, it is possible to funnel assets to a divorcing spouse without paying a penalty or inclusion of the distribution in AGI.
As mentioned earlier, the penalty for early distributions from qualified retirement arrangements is 10% of the taxable distribution. As with most things in the IRC, there are exceptions to the early distribution penalty. Some of the exceptions involve death, disability, or separation from service, and are not germane to this discussion. I will only discuss the exceptions that could have an impact in a divorce environment. Additionally, it is important to note that distributions from IRAs may be subject to different penalty exception rules.
One exception to the 10% early distribution penalty, which could have some application in the context of a divorce, is a distribution used to pay deductible medical expenses. This will likely occur only in the most narrow of circumstances where one spouse proposes to pay off another spouse’s medical expenses as part of the property settlement negotiation. In order for this exception to work, the amount distributed from the qualified retirement arrangement must be equal to or less than a taxpayers' DEDUCTIBLE medical expenses. This doesn’t mean ALL medical expenses, only those non-reimbursed medical expenses that exceed 10% of the taxpayers' AGI. For example, if the taxpayers' AGI is $100,000 and non-reimbursed medical expenses are $8,000, none of the medical expenses are considered deductible because the amount doesn’t exceed the 10% AGI threshold. If the non-reimbursed medical expenses were $12,000, $2,000 of this amount would be considered deductible medical expenses. A retirement plan distribution of $2,000 or less could be taken and the taxpayers would avoid the 10% early distribution penalty on the retirement plan distribution. The distributed funds must be used to pay the medical expenses (as stated by the United States Tax Court), and the payment of the expenses must happen in the same tax year as the distribution. Because of this requirement, it is likely that the spouses would need to be eligible to file their return jointly.
Although not specifically stated, I suspect both the distribution and deductible medical expenses would need to appear on the same return. Although the above described early distribution exception protects the taxpayers from the imposition of the 10% penalty, the amount distributed will be included in the distributee’s AGI in the year of receipt.