IMPROPER ROLLOVER FROM PROFIT-SHARING PLAN TO IRA MAY CAUSE TAX PROBLEM
Generally, distributions from a qualified pension or profit-sharing plan will be taxedto the employee in the year the distributions are received unless they are "rolledover" into an eligible retirement plan. Tax-free rollovers are meant to protectretirement benefits when an employee either changes jobs or the retirement plan terminatesso that the tax-deferred benefits the employee has built up can be used for the employee'sretirement savings. A Qualified Domestic Relations Order (QDRO) allows the planadministrator to create a separate account or to distribute benefits, but this court ordermust specifically state the names and addresses of both the participant and the alternatepayee, the share of benefits which will be paid to the alternate payee, the length of timeor number of payments, and a description of each plan covered by the order. But poorplanning and not understanding the rules can cause nightmares.
Here are the facts of an actual case where an improper roll-over caused $150,000 ofmore than $300,000 to go to taxes. About a year after Wife filed for divorce, Husband'semployer terminated its profit-sharing plan. At this time, Husband took the entire balanceof his profit-sharing plan and turned it over to his Wife. Wife opened an IRA with themoney within 60 days and, later in the year, Husband and Wife signed an agreement whichwas made a part of the divorce decree. This agreement provided that Wife was to receive aninterest in Husband's profit-sharing plan.
In order to take advantage of a tax-free rollover, distributions from a pension orprofit-sharing plan must be rolled into an IRA created for the exclusive benefit of theindividual or his or her beneficiaries. The law does not allow an employee to escape taxon a distribution from qualified money by transferring it for the exclusive benefit ofanother person. That's where the QDRO comes in. A QDRO is designed to either create orrecognize an Alternate Payee's right to receive benefits from a retirement plan, or assigna portion of the benefits to someone other than the plan participant. Distributions thatare made to an alternate payee according to a QDRO may be eligible for a tax-free rolloverto an IRA if the rules are followed.
Here, because this divorce became final months after the plan had terminated and thelump-sum distribution had been made, the order was not a QDRO. And because thedistribution and transfer went into an IRA for the Wife, not the Husband, it did notqualify as a tax-free rollover. In this case, there was another problem: Although Wifereceived the entire amount and placed it in her IRA, the agreement provided that Wife wasentitled only to the community property portion of the plan.
After an audit, the tax court determined that the transfer was not a tax-free rolloverto an IRA and that the couple's divorce decree was not a QDRO. Bottom Line: Husband wasrequired to pay ordinary income taxes plus a 10% penalty on the premature distributionfrom his profit-sharing plan in addition to a 15% excess distribution pentaly tax on theamount over $150,000 -- which was offset by the early distribution penalty -- and Wife wasrequired to pay 6% excess contribution penalty on the amount over $2,000 that wascontributed to her IRA.
If the Husband and Wife had properly drafted their agreement and had the QDRO issuedbefore the Husband took the distribution from the plan, it is likely that they would haveavoided taxes and penalties.