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How do I deal with a divorce settlement from an IRA?

December 15, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Q: I am receiving my divorce settlement from my husband's IRA. They told me that now I have to put it in another IRA account. Is that true? I need some of that money to pay down debt. I am 61 - does my age help?

A: According to the Internal Revenue Service, a divorce settlement from a spouse's individual retirement account effectively becomes a new IRA on behalf of the person receiving the settlement. So, to avoid tax consequences on the total amount, you would be wise to put the money into an IRA, and then look at how best to take distributions from that IRA to meet your needs.

First of all, you should arrange for the transfer of the money to be done via a trustee-to-trustee transfer, rather than by you receiving a check. This will clarify that it is a non-taxable transfer from IRA to IRA.

Transferring from a traditional IRA vs. Roth IRA

Another important thing to establish in this process is whether the money is coming from a traditional or a Roth IRA. You'll most likely want to transfer into the same form of IRA to avoid unfavorable tax treatment. However, if it is a Roth IRA you should establish with your new trustee whether or not your IRA will be subject to the five-year waiting period on distributions from a Roth IRA, or whether the original start date of your husband's account can be carried over to yours.

Once the transfer occurs, and if you are not subject to that five-year waiting period for a new Roth IRA, the good news is that because you are older than age 59 1/2, you can take distributions from your IRA without penalties. However, the absence of penalties does not mean there are not potential tax consequences.

Non-deductible vs. deductible contributions

The key difference between a Roth and a traditional IRA is that a Roth is funded with non-deductible contributions, while a traditional IRA is funded with deductible contributions. What this means, in effect, is that tax has already been paid on money going into a Roth, but not on money going into a traditional IRA. Because of this, distributions from a Roth IRA are not treated as ordinary income for tax purposes, but distributions from a traditional IRA are.

That means that while you should not have to pay an early-distribution penalty on distributions from a traditional IRA because of your age, you would still have to pay regular income tax on those distributions. Since these distributions are treated as ordinary income, you should manage the timing of those distributions to avoid taking too much out in any one tax year. That could bump you up into a higher tax bracket.

The above are some general guidelines on what to look for, but keep in mind that it is difficult to generalize when it comes to tax topics. There are often specifics of a person's situation that could affect tax consequences, so you should consult with your IRA trustee or a tax advisor before taking any actions.

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