What do you get when community property rules mix with retirement plan rules? As one widow recently discovered, the two sets of rules don't always play nicely together.
In a recent private letter ruling, the IRS said no to a surviving spouse who wanted to roll over her deceased spouse's IRA, even though a state court awarded her a community property interest in the IRA.
Advisers must understand how state community property and retirement plan tax rules interact. When a marriage ends, either by death or divorce, it should be determined who gets the property, including the retirement accounts. State property laws provide much of the guidance in this area.
Generally, there are two systems of state property law: Most states use the common law system, while approximately 30% of Americans live in community property states.
For community property rules to apply, a client must have two things: a valid marriage and a domicile in a community property state.
RETIREMENT PLAN RULES
When it comes to determining who gets the retirement plan funds after the death of a spouse or a divorce, community property rules come into play. Because community property law can dictate who gets an IRA after death, it must be taken into account when a client names a beneficiary on an IRA.
In a community property state, state law may recognize a spouse as the beneficiary of some or all of the IRA. Therefore, IRA owners may need to get a spouse's written consent to name someone else as the beneficiary of their IRA.
Some IRA custodians have beneficiary designation forms with language for spousal consent to name a non-spouse beneficiary. Others do not.
Clients with no connection to a community property state can name whomever or whatever they want as their IRA beneficiary.
What about company plans? It depends on whether the plan is covered under ERISA's spousal rules. In general, ERISA-covered plans require that a spouse be the participant's beneficiary, unless that spouse has waived their rights to the plan assets.
ERISA TRUMPS COMMUNITY PROPERTY
What happens when state community property rules conflict with the retirement plan rules? In the landmark case of Boggs v. Boggs, the U.S. Supreme Court ruled that, when there are conflicts, ERISA trumps community property law.
The Boggs case involved a dispute over Isaac Boggs' plan benefits. After his death, his second wife faced off with his children from his first marriage. The children argued that they had received an interest in the plan benefits through their mother's will, because she had a community property interest in the plan under state law.
The Supreme Court, however, made a 5-4 decision that the children's rights derived from community property law were trumped by the second spouse's protection under ERISA.
What happens to community property in a company plan when there is a divorce? Once a spouse has been determined to have a community property interest in the company plan benefits of the other spouse due to divorce, a qualified domestic relations order must be obtained to direct the holder of the retirement plan to retitle it to the ex-spouse.
A QDRO is an exception to ERISA's requirement that plan assets cannot be assigned or alienated during the participant's lifetime. In contrast, IRAs are not governed by ERISA, and a QDRO is not necessary.
IRAS AND COMMUNITY PROPERTY
Community property rules may determine who is entitled to the IRA after a divorce or death. However, for federal tax purposes, the IRS has said IRAs are deemed separate property, even if the funds in the account would otherwise be community property.
These distributions are taxable to the spouse whose name is on the IRA. That spouse is also liable for any penalties and additional taxes on the distributions.
In the seminal case of Bunney v. Commissioner, the Tax Court held that, even though spouses are equal owners under community property law, the IRA owner pays the tax on a distribution he gives to an ex-spouse.
In this case, Michael Bunney and his wife divorced. He withdrew funds from his IRA and gave the funds to his former wife as payment for her interest in their home. Bunney claimed that, under community property law, half the IRA already belonged to his former wife. Therefore, the distribution should not be taxable to him.
The Supreme Court disagreed and handed Bunney the tax bill, because the distribution came from his IRA.
Clients facing a community property claim to their IRA in a divorce will want to avoid Bunney's fate. A court order for a transfer incident to the divorce, often found in the marital separation agreement, will be needed. By doing a trustee-to trustee transfer, the amounts awarded as a community property interest in a divorce can be moved from one spouse's IRA to the other's without negative tax consequences.
DEATH V. DIVORCE
Now let's get back to the married couple at the beginning of this story. The people referenced in this IRS private letter ruling are real but these documents do not name their subjects. So let's call them Tim and Denise. The couple lived in a community property state and had a son we'll call Jake. Tim named Jake as the sole beneficiary of his three IRAs.
When Tim died, a couple of things happened.
First, the IRA custodian retitled the accounts as inherited IRAs for Jake. In addition, Denise filed a claim against Tim's estate for her one-half interest in the community property she and Tim owned.
She then negotiated a settlement with Tim's estate, under which her community property interest in the estate was valued at an agreed upon amount (let's say $500,000). A state court approved the settlement and ordered that the IRA custodian assign $500,000 of Jake's inherited IRAs to Denise as a spousal rollover IRA.
After her success in state court, Denise requested a PLR asking the IRS for a favorable ruling following the terms of the court settlement. The IRS declined Denise's request, stating that "the order of the state court cannot be accomplished under federal tax law."
The IRS said that, because Jake was the beneficiary of Tim's IRAs, the IRAs became inherited IRAs for Jake. Denise was not the named beneficiary.
Because community property interests are disregarded under federal tax law, Denise cannot be treated as a payee of the inherited IRAs, and may not roll over any amounts.
A PAINFUL TAX BILL
Additionally, because Jake was the named beneficiary of the IRAs and Denise's community property interest was disregarded, any assignment of an interest in the inherited IRAs to Denise would be treated as a taxable distribution...to Jake.
While the IRS has often been generous to surviving spouses in PLRs, allowing spousal rollovers even when a trust or an estate was the named beneficiary on an IRA, that was not the case here.
This is why it is essential that advisers with clients in community property states check all IRA beneficiary forms, to see if the named beneficiary is someone other than the spouse. Tell clients that IRS tax rules do not recognize a spouse's community property interest in his or her spouse's IRA.
For example, if the IRA owner wants his son to be the beneficiary, have the spouse waive her community property interest in that IRA, if she agrees. If she chooses not to waive, it's best to name her as the IRA beneficiary and look to other assets that could be left to the son in lieu of the IRA. This could avoid a big tax mess after death.
Ask clients where they have lived in the past and where they plan to live in the future, in order to identify community property concerns that may impact their retirement plans. Don't assume that, because clients currently reside in a common law state, community property concerns are off the table.
Also, watch out for federal tax issues with IRAs and community property interests. A state court order awarding a client a community property interest in an IRA may not be effective for federal tax purposes, and may come with a painful tax bill.