THE QUESTION
Are both spouses eligible for the same tax treatment of disability retirement benefits paid as required by a divorce agreement?
THE DISPUTE
Taxpayer Says: The benefits should be nontaxable because she received them under a divorce agreement and she should qualify for the same tax treatment as her former spouse.
Internal Revenue Service Says: The benefits are taxable to the taxpayer because she does not meet any of the exceptions available to exclude it.
THE LAW
From Internal Revenue Code Section 61(a): Defines gross income as “all income from whatever source derived, including * * * (11) Pensions”, unless otherwise provided.
From Internal Revenue Code Section 104(a)(1): Provides an exception to Section 61(a) by authorizing an exclusion with respect to compensation for injuries or sickness.
From Internal Revenue Code Section 402(e)(1)(A): Provides that an alternate payee pursuant to section 414(p) (which defines a qualified domestic relations order) who is the former spouse of the participant shall be treated as the distributee of any distribution of payment made to the alternate payee under a qualified domestic relations order (QDRO).
THE CAUSE OF THE DISPUTE
Generally, distributions from qualified pension plans are taxable income when you receive them. That’s typically true even when the payments are made to someone else, such as a former spouse.
One exception to the general rule of taxability is payments you receive due to personal injuries or sickness incurred in the course of your employment. Those payments are not taxable to you.
In addition, when a former spouse has a right to receive part of the distributions, you can use a tax law concept known as a Qualified Domestic Relations Order (QDRO), to transfer the tax burden to your former spouse. QDROs apply to qualified plans, though section 414(p)(11) of the Internal Revenue Code allows distributions from certain government plans to be treated in the same manner as those made pursuant to a QDRO.
In this case, the taxpayer’s former husband retired from the Los Angeles Sheriff’s department after suffering a service-connected disability. The payments he received qualified for the disability exception and were not taxable to him.
The taxpayer received part of the disability payments as part of the divorce agreement. She also received Form 1099-R from the retirement plan at year end. She did not report the payments on her tax return. She believed the payments were not taxable to her because they were not taxable to her ex-husband, and she received them under what was effectively a QDRO. Therefore, she should be treated, tax-wise, the same way as her former husband.
The IRS agrees the former husband’s pension was based on injuries he sustained on the job, and the distributions were not taxable to him. However, the IRS says the payments are taxable income to the taxpayer because she was not the one injured on the job.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.
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