When couples divorce, it seems obvious that they should change their beneficiary designations on a variety of accounts. But a recent case before the U.S. Supreme Court shows that sometimes such paperwork slips through the cracks - and highlights the disarray that can arise as a result.
The court ruled earlier this year in Hillman v. Maretta that a decedent's ex-spouse, who was still named as his beneficiary, was entitled to receive his federal life insurance benefits. The unanimous decision came despite the fact that an applicable state law says that a divorce removes an ex-spouse as the beneficiary of a decedent's various death benefits.
While this is an insurance benefits case, it could be applied to IRA and other retirement beneficiaries who, as a result of poor planning, might find themselves disinherited similarly.
The case dates back to 1996, when Warren Hillman named his wife, Judy Maretta, as the beneficiary of his Federal Employees' Group Life Insurance policy. Two years later, however, the couple divorced.
In 2002, Hillman remarried, and remained married to his new wife, Jacqueline, until his death at age 66 in 2008. But as it turned out, even though he had divorced Maretta 10 years earlier and had been remarried for six years, Hillman had never updated the beneficiary form. On the date of his death, his ex-wife was still his named beneficiary.
Because of conflicting federal and state laws, a dispute ensued over the rightful recipient of the federal life insurance benefits. First, a Virginia state law directly opposed Hillman's beneficiary designation. The law reads in part: "Upon the entry of a decree of annulment or divorce from the bond of matrimony on and after July 1, 1993, any revocable beneficiary designation contained in a then-existing written contract owned by one party that provides for the payment of any death benefit to the other party is revoked."
Translation: Under the state law, when a couple divorces, they are no longer treated as each other's beneficiaries - even if their beneficiary forms say otherwise. On its own, this suggested that Maretta would no longer be entitled to receive Hillman's life insurance benefits of nearly $125,000.
But a provision of the federal law that created the benefits contradicts the Virginia statute. Part of this law states explicitly that its provisions supersede any state laws that may differ. It says, "Provisions of any contract ... which relate to the nature or extent of coverage or benefits (including payments with respect to benefits) shall supersede and preempt any law of any state." That provision specified that the benefits be paid to Maretta.
There was another complicating factor: An additional provision in Virginia's law called into question whether she would be able to keep those benefits. Under the state law, if the provision removing an ex-spouse as the beneficiary of the death benefits is overridden by federal law, an ex-spouse receiving those benefits could be held personally liable to the person who would have otherwise received them.
In other words, in this situation, even though Maretta would receive Hillman's insurance benefits, she could be forced to turn over those benefits to Jacqueline Hillman.
The U.S. Constitution contains a provision known as the Supremacy Clause, which establishes the Constitution and other federal statutes as the supreme law of the land: When a federal law and a state law are pitted against each other, the federal law gets preference. Both Maretta and Jacqueline Hillman agreed that this rule allowed the federal statute to preempt the Virginia law and leave Maretta as Warren Hillman's insurance beneficiary. This, however, is where the agreement ended.
Jacqueline Hillman believed Maretta could be compelled to turn over the insurance benefits under the second Virginia state law provision without violating any federal legislation.
Maretta, on the other hand, believed the intent of the federal law was to make sure that whoever is designated as the beneficiary receives and keeps the benefits. Unable to agree, the two sides wound up in court.
Much like the back and forth in the laws, the courts themselves went back and forth as to who should ultimately get the money. The case was first heard by the Virginia Circuit Court, which decided in favor of Hillman. In its opinion, the Virginia state law holding Maretta liable to Hillman was not in conflict with the federal law.
But Maretta appealed to the Virginia Supreme Court. In a split decision, the justices reversed the Circuit Court's decision and awarded the insurance benefits to Maretta. In its opinion, both Virginia state law provisions were superseded by the federal rule preempting state law.
This past June, the U.S. Supreme Court decided the issue for good: It unanimously affirmed the Virginia Supreme Court's decision to award Maretta the benefits. In the court's opinion, written by Justice Sonia Sotomayor, the Virginia statute holding her liable to Hillman for the insurance benefit "interferes with Congress' scheme, because it directs that the proceeds actually 'belong' to someone other than the named beneficiary."
Potentially more interesting for advisors, the court also noted that many Americans fail to update their beneficiary forms properly and that Congress was aware of that glitch. Therefore, had Congress wanted certain benefits to be awarded to someone other than a named beneficiary - such as a current spouse - it could have passed legislation to do so.
The justices also declared that to decide otherwise would be viewing the federal statute so narrowly that states could easily create laws to work around its true intention.
In the decision, the court cited two cases in which it had decided in a similar fashion. The cases, Wissner v. Wissner (1950) and Ridgway v. Ridgway (1981), both dealt with state statutes that tried to override federal laws that are "strikingly similar" to the federal benefits law. In both cases, the court held that the federal law trumped any conflicting state statute and that the person named on the beneficiary form trumped other interests.
Similarly, in 2009, the Supreme Court decided in Kennedy v. DuPont that, despite having waived her rights in a valid spousal waiver, the ex-wife of a plan participant was entitled to funds intended to be left to the participant's daughter because she was still the named beneficiary. That decision was also unanimous.
The daughter in that case was disinherited from $402,000 of her father's 401(k); he had wanted the money to go to her, but he had never updated his beneficiary form to remove his ex-wife after his divorce.
ATTENTION TO DETAIL
In the Hillman case, it's important not to read the Supreme Court's decision too broadly. The court did not say that the Virginia state law was unconstitutional, nor did it find any issue with the law in general. Instead, it simply decided that the state law was in conflict with federal law.
But that raises a question: Would the beneficiary form still trump other provisions, even if they were not in conflict with a federal statute?
The Supreme Court decision does not say that state statutes, such as the one in Virginia, can't be applied to other assets with death benefits, such as IRAs, when there are no competing federal laws.
Similarly, some IRA custodians themselves now have similar provisions as part of their custodial agreements, where a divorced spouse is no longer treated as the beneficiary of their ex-spouse's IRA unless there is another, affirmative election after the divorce has been finalized.
Unlike federal life insurance benefits, these IRA agreements are not truly governed by federal law. Therefore, it's conceivable that the courts could decide that such a provision would be valid, and award an inherited IRA to someone other than the named beneficiary.
LAST WISHES UNFULFILLED
The common thread running throughout these cases, though, is that the decedent's wishes were not carried out. Long court battles ensued because no one took the time to update a simple beneficiary form.
This is a very preventable mistake that can be avoided with such a modest effort. Advisors should make sure to conduct regular beneficiary form reviews to avoid similar problems for their clients.
This year's Supreme Court ruling makes one issue particularly clear for advisors: Don't count on a state law or a custodial contract to avoid having an IRA or other assets pass to an ex-spouse or other unwanted beneficiary.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of many books on IRAs.