A recent U.S. Tax Court decision illustrates the sometimes limited value of "good intentions."
In Summers, TC Memo 2017-125, a young couple decided to save money and amicably work out their own divorce agreement without obtaining tax or legal advice. As part of their plan, the husband took a distribution from his IRA and gave half of it to his soon to be ex-wife so she could pay some personal debts prior to finalizing the divorce.
'Additional Tax' on Early Distributions
Generally, distributions from retirement plans, including IRAs, are fully taxable as ordinary income (unless rolled over to another qualified retirement plan or IRA). Distributions that occur before certain dates can also result in a 10 percent additional tax unless a specific exception applies. For example, one of these exceptions can apply when an "early" retirement plan distribution, otherwise subject to the additional tax, is made to a spouse or former spouse under a qualified judgment, decree or order of a state court.
The taxpayer in the Summers case felt he met the "spirit" of this exception. However, he failed to follow requirements set forth in the tax law because:
Consequently, the IRS assessed additional tax equal to 10 percent of the IRA distribution.
The Tax Court expressed "considerable sympathy" for the taxpayer's position. However, his failure to comply with the statutory requirements for an exception to the 10 percent additional tax compelled the court to agree with the IRS's assessment.
This result serves as a reminder of the value of professional advice in advance of entering into financial transactions. With proper planning, it is possible the couple in this case could have achieved an acceptable financial result and reduced significantly the husband's income tax consequences.