IRA Withdrawal Penalty A Cost Of Do-It-Yourself Divorce

Divorce 101 written on a yellow piece of paper

Today’s lesson in the tax aspects of divorce from Tax Court Memo Decision 2017-125  is an illustration of Reilly’s Fourth Law of Tax Planning – Execution isn’t everything but it’s a lot.  The name of the petitioner is there for you, if you want to know, but I figure he doesn’t need me to help make him famous.  I’ll call him Robin and his wife Terry, my favorite mythical couple.  Robin got a pat on the head from the Tax Court and even a tad of sympathy from the IRS, but he is still going to have to pay the $1,738 early withdrawal penalty that the IRS hit him with on his IRA distribution.

Robin wanted to save money on legal fees.  He may well have on net, but that early withdrawal penalty really hurts. Here is what happened.  Robin and Terry had four children.  They considered their marriage irretrievable,  but wanted to minimize difficulties for the kids.  As Judge Lauber puts it:

To their credit they were determined to do this in the least acrimonious manner possible. And to minimize costs they decided to accomplish their divorce without involving lawyers.

They reached agreement on child custody, visitation rights, child support, spousal maintenance and division of property.  Robin filed a petition for dissolution that incorporated the agreements.  Among the assets was an IRA account with about $17,000.

As these matters were being worked out, Terry was plagued by debts.  Robin cleaned out the IRA  withdrawing $17,378.  He used $8.618 to pay down Terry’s car loan.  Subsequently he sent her $71 to true up.  I have to say I admire that kind of precision.

A couple of months later the court entered a consent decree for the dissolution of the marriage incorporating the agreements that Robin and Terry had made.  Since the IRA account had been cleaned out there was no mention of it.  Robin reported the $17,378 on his return but did not report any “additional tax” on line 58. The custodian of course had ratted him out, by sending the 1099 to the IRS with “early distribution, no known exception” indicated.

The IRS admitted that with respect to the portion that had gone to Terry, things could have been structured to avoid the penalty under Section 72(t)(2)(C) (“Payments to alternate payees pursuant to qualified domestic relations orders”).  Woulda, coulda, shoulda.  Robin failed to meet the exception for two reasons. Terry did not receive the money directly and as it worked out there was no QDRO.

the distribution was not made “pursuant to a qualified domestic relations order.” Although Jeremy’s petition for dissolution of marriage requested a 50-50 division of the IRA, any judicial action on that request was pretermitted by his well-intentioned decision to divide the IRA with _____ a month before the divorce decree was entered. That decree accordingly recited that “[n]either party has a retirement, pension, deferred compensation, §401(k) Plan and/or benefits.” The IRA distribution was not made “pursuant to” that order or any other judicial decree.

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