February 1, 2018
Dividing traditional and Roth IRAs in a divorce is not complicated. No special forms are needed (other than the divorce decree) and the transfer to the receiving spouse is non-taxable as long as the money is received into that spouse’s IRA (or Roth IRA) account. However, dividing an inherited IRA is a bit more complicated. There are special considerations when dividing this type of account.
First let’s understand what an inherited IRA account is. Joe opened a traditional IRA and designated Jane, his daughter, as his beneficiary. When Joe died Jane inherited the account. If Jane had been Joe’s wife she could have transferred Joe’s IRA money into her own IRA. But because she is a “non-spouse beneficiary” she does not have that option. Instead the custodian transferred the money from Joe’s IRA into a special account called an “Inherited IRA”. Jane cannot contribute to this IRA, and she can’t commingle this money with her other IRA accounts. In addition she is required to take a minimum amount out of the account every year, regardless of how old she is. The amount she must withdraw is based on the account value and her age. Other than that, she can invest the money or take other distributions (above the minimum required amount) at her discretion. As with other IRAs, each distribution is taxable to Jane at her ordinary tax rate.
Five years after Jane inherits her father’s IRA, she and her husband Brian decide to divorce. Jane’s inherited IRA can be split or awarded to Brian, just like a traditional IRA. For the portion of the account that Brian receives, he steps into the shoes of the “non-spouse beneficiary” of the account. Just like Jane, he will have to take a required minimum distribution each year even if he is under the “minimum retirement age” of 70 ½. The distributions will still be based on Jane’s age even though Brian is the new account owner.
The potential for errors in this situation are many. First Brian has to know that he cannot combine the inherited IRA money with his own IRA money. Also he must be made aware of his obligation to take an annual distribution and he must calculate the proper amount, so that he doesn’t miss this important requirement - he could be penalized by the IRS if he does. He should also factor the distributions into his taxable income.
If you have not already done so, you are bound to run into a case with an inherited IRA soon. Now you will know how to help your client treat this account appropriately.