L.P. from Orlando, Fla. writes:
My husband and I divorced earlier this year. As part of the agreement, some of my ex-husband's IRA was transferred into my name. I was told that we both need to file a form that indicates a change of basis. But I thought this exchange was tax-free. How can I avoid the tax?
The good news for you is that the transfer qualifies as a tax-free exchange.
It sounds like the funds in the IRA are divided between you and your husband. As a result, both of you should file Form 8606 (Nondeductible IRAs) to reflect the account holdings' change in basis. But no tax is due if you're simply transferring the funds.
Tax law says you must use your ex-husband's basis in the account to determine your basis going forward. (IRC Sec. 1041(b)(2); Reg. 1.1041-1T)
How? Let's say your spouse's IRA is worth $200,000 and he transferred half of it to you as part of the divorce. Assume that his basis in the IRA was $50,000. In that case, you are entitled to receive $100,000 and transfer it to an IRA in your name. Your basis for this IRA is $25,000 (half of $50,000).
You can roll over the funds tax-free to a new IRA established in your name or to an existing IRA without paying any tax. Another option: You could take owner-ship of your ex-husband's IRA and then your husband could set up a new IRA to hold the remaining half of his IRA funds.
Remember, a transfer of funds is tax-free. But if you choose to tap into the IRA now, you'll pay tax on the distribution, plus a 10 percent early-withdrawal penalty if you are under age 59 1/2.
Consult with a tax pro if you have questions about the allocation of basis or filling out Form 8606.