Pity the Enrolled Agent tax expert who deals with individuals taking distributions from their retirement plans. A variety of possible tax consequences must undergo consideration. Moreover, explaining the impact to taxpayers is often uncomfortable. Many people are discouraged to learn that early distributions before retirement age trigger a 10 percent additional tax – even when a court orders the distribution.
Retirement accounts are by their nature solely owned by individuals. However, married persons equitably share the values of these accounts, which are often divided upon divorce. Family courts issue Qualified Domestic Relations Orders for divorcing couples to achieve fair division of marital estates. But, an IRA plan administrator may divide the account between divorcing spouses without a QDRO. For instance, Enrolled Agent courses provide instructions that division of an IRA incident to divorce is not a taxable event.
The administrators for other types of retirement plans require a QDRO to attain tax-free division of an individual’s account. A QDRO recognizes the right to some or all of a retirement account by an “alternative payee” instead of the account owner. An alternative payee is “any spouse, former spouse, child or other dependent” of the participant in the retirement plan. Amounts distributed from a retirement account without a QDRO create severe tax consequences for the unfortunate plan participant.
Charles Hartley apparently did not obtain an explanation of his tax circumstances from an Enrolled Agent. Even if he had, he might still have taken his case to Tax Court because his tax assessment seems so unfair. Nevertheless, a tax professional with EA certification is forced into the uncomfortable position of conveying bad news to people in Hartley’s situation. A judge ended up giving Hartley the unpleasant truth.
Hartley had withdrawn $52,684.11 from his retirement plan account to pay a court-ordered property settlement to his ex-wife. He seemingly understood that the distribution was taxable because his tax deficiency assessed by the IRS was $5,268. This is only the computed 10 percent additional tax that penalizes early distributions. Interestingly, the original statutory notice of deficiency from the IRS stated an amount of $2,968. The notice was subsequently amended when the IRS figured out how to multiply by 10 percent.
No QDRO was ever prepared with respect to Hartley’s retirement plan. Perhaps the reason for this is that his ex-wife intended to obtain spending money rather than funds locked in a retirement account of her own under a QDRO. The Enrolled Agent job when a QDRO is issued entails an alternative explanation of the tax consequences than Hartley encountered. That is, Hartley’s ex-wife would owe tax – including any early distribution penalty – when she withdrew funds from her divided share of Hartley’s retirement account.
Because Hartley’s distributions were directly to him rather than to an alternative payee, the incidence of tax is his burden alone. Hartley needed advice from someone with Enrolled Agent training before following the directive of the family court. That would have precipitated a request by his attorney for a QDRO. As things unfolded, Hartley was blindsided with more financial loss caused by the tax assessment while his ex-wife received tax-free money.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.