In law school, one of our professors noted the irony of divorce settlements. It’s funny, she remarked, that two people who often found it difficult to talk about money when they were married are now required to discuss it at a time when they may no longer talk to each other about anything. Even when family lawyers are involved in facilitating, it can be hard to agree on a distribution scheme—and even more challenging to carry it out. One taxpayer figured this out the hard way, drawing additional taxes from the Internal Revenue Service (IRS) for an early withdrawal from a retirement account.
Here are the facts of the case. On October 29, 2014, William Rosenberg reached a settlement agreement with his ex-wife. Under the agreement, she was required to pay him $10,000 from her retirement account as a reimbursement for his payment to her of liquidated retirement proceeds during their marriage. Simple enough, right?
In 2015, Rosenberg’s ex-wife transferred the retirement funds to him. However, instead of withdrawing the funds from her retirement account and paying Rosenberg directly, she moved the funds to a temporary IRA that Rosenberg set up at Merrill Lynch. Within a week of the transfer, Rosenberg withdrew the funds and closed the account. He was not yet 59 1/2 years old at the time of the withdrawals.
You know what’s coming, right? In 2016, Merrill Lynch issued a form 1099-R, Distribution From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to Rosenberg. The form reflected a withdrawal of $9,875, which was $10,000 reduced by a $125 withdrawal fee. Separately, Rosenberg had also taken out $245 from an IRA he held at Fidelity Investments (Fidelity); he received a form 1099-R from Fidelity, too.
On his 2015 tax return, Rosenberg reported the Fidelity withdrawal but not the Merrill Lynch withdrawal. The IRS sent a notice of deficiency, increasing Rosenberg’s taxable income to include the Merrill Lynch withdrawal and assessed an additional 10% early-withdrawal tax for both withdrawals under Tax Code section 72(t)(1).
There is an exception under section 72(t)(1) for transfers as part of property settlements related to a divorce or separation. To qualify, the distribution must be made under a qualified domestic relations order, sometimes called a QDRO (pronounced “qua-droh”), with the exception carved out.
But that’s not what happened here. Nonetheless, Rosenberg argued that the Court should disregard the entire transaction and treat it as though his ex-wife had merely paid him cash. Rosenberg reasoned that he just wanted the money, and his ex-wife made him jump through the extra hoops. He claims that he didn’t believe that those steps in the middle would result in additional tax, and since it wasn’t what he intended, the IRS should just overlook the IRA bits and treat him as though he had received the cash outright.
It’s a pretty bold argument. It also wasn’t successful. The Tax Court ruled in favor of the IRS, finding that the interim transactions were taxable and also subject to the penalty.
So what could Rosenberg have done differently? I don’t know how old he was, but if he didn’t immediately need the cash and wanted to avoid the penalty, he could have waited until he turned age 59 1/2. If he didn’t want to wait, he could have negotiated terms requiring a cash payment made to him directly, or he could have spelled out the terms of the transfer in a QDRO. That said, a QDRO doesn’t mean that distributions from a retirement plan are tax-free. Distributions made as part of a QDRO would generally be taxed in the same manner as a regular distribution. However, an exception applies for cash payouts that are not subject to the early-withdrawal penalty under a QDRO. Those tax consequences should be taken into consideration when determining the split at the time of the drafting of the QDRO—and not after.
I often tell taxpayers to make friends with a tax professional. I stand by that advice. But here’s an add: Make sure that your family law and other attorneys are also friends with a tax professional. You’ll be glad that they are.
The case is William Elias Rosenberg, Petitioner v. Commissioner of Internal Revenue, Respondent, TC Memo 2019-124.
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