3713.02 / How can a taxpayer’s Roth IRA savings be impacted by divorce?

One critical issue that clients may overlook when transferring Roth assets pursuant to a divorce settlement is the so-called “five-year rule” that applies to distributions from Roth IRAs.

Typically, all withdrawals from a Roth IRA are taken on a tax-free basis. That includes both contributions and earnings on those contributions because the account owner pays taxes on the contributions before they are contributed.

However, the distribution must be a “qualified distribution” for the earnings on after-tax contributions to receive tax-free treatment. A distribution is only “qualified” if it is taken after the five-year period beginning with the first tax year that the owner opened the Roth IRA and made a contribution to the account. This is known as the “five-year rule.”

Distributions that are taken within five years of the date the account is opened will be subject to ordinary income tax to the extent that those distributions represent earnings on after-tax contributions. In other words, the contributions themselves will not be subject to tax a second time. The distribution could, of course, be subject to the 10 percent early withdrawal penalty if the client is not yet 59 ½ (unless another exception to the penalty applies).

The IRS does not provide concrete information when it comes to understanding how the five-year rule applies when one spouse transfers a part of their Roth IRA assets to a former spouse as part of a divorce settlement. However, the IRS has offered guidance on how the five-year rule works when someone inherits a Roth IRA.

When a client inherits a Roth IRA, they do not have to restart the five-year clock. The period that the original account owner had the assets in the Roth IRA transfers to the beneficiary. For example, if the original account owner had opened and funded the account three years prior to their death, the beneficiary only must wait two years before earnings on account contributions can be withdrawn tax-free.

Most tax experts agree that these rules also apply when a client who owns a Roth IRA transfers those funds to a former spouse incident to divorce. The character of the account assets (as either after-tax contributions or earnings on those contributions) should also transfer to the former spouse. The amount transferred to the former spouse will also contain a pro-rata combination of contributions and earnings.

It is also possible that a client could be impacted by the five-year rule if they have to withdraw Roth IRA funds sooner than expected because of a divorce. For example, the client may need the funds to pay for a new home or cover attorneys’ fees. Those funds may not always be tax-free if the account has been open for less than five years. It is also possible that early withdrawal penalties could apply unless the client qualifies for one of the exceptions to the
10 percent early distribution penalty.

Once a divorce becomes final, each spouse can continue contributing to their own Roth IRAs as long as they satisfy the income restrictions that apply to Roth IRAs.