Take-Away: The intersection of federal qualified plan retirement law and community property law is very clear. Federal law trumps state community property principles for qualified plans. But the law is much more muddled when it comes to community property rights in a spouse’s IRA. So while the law is clear with qualified plans, it is pretty confusing when it comes to IRAs.

Example: Husband, a resident of California, fathered a son while in his early 20’s. Husband’s marriage then ended in a divorce. Husband shortly afterwards remarries, and he remains married to his second wife for thirty-five years, all the time living in California, a community property state. Throughout the second marriage husband participated in his employer’s 401(k) account. At age 63 husband retires and promptly inherits a home in northern Michigan. Husband and his wife decide to move from California to Michigan to enjoy their retirement in the Midwest. Once in Michigan Husband rolls over his 401(k) account balance to an IRA. Husband wants to name his son from his first marriage as the beneficiary of the IRA, but he prefers to not tell his wife about that choice of beneficiary designation. Does husband need his wife’s consent to his IRA beneficiary designation. The answer is ‘legally no, practically  yes.’

Background: Community property laws describe the rights of each spouse with respect to the management, control and disposition of their community property. The federal ERISA law also sets forth rules that govern the management, control and  disposition of qualified retirement plan account balances.

  • Federal Preemption:  With this tension between state and federal law as to the control of assets held in a qualified plan, the Supreme Court got involved and answered the question concluding that ERISA preempts state community property law. Boggs v. Boggs 117 S. Ct. 1754 (1997). Thus a spouse’s contributions to a 401(k) plan will be treated as contributions of non-community property assets,  assets to which community property principles do not apply. But the spouse is somewhat protected with ERISA’s mandated preretirement and retirement joint and survivor annuity forms of benefit.
  • IRAs and Boggs: But ERISA does not apply to IRAs. Boggs left unanswered  whether ERISA preempts state community property law for IRAs, even though the largest asset at issue in Boggs was an IRA. In that case before the Court, the husband had established an IRA to hold a lump sum distribution that was made from a defined contribution qualified plan after his wife’s death. The children of the marriage claimed an interest in the IRA, through their deceased mother (her community property interest traced to the IRA), causing the litigation. The Court noted: “Both parties agree that ERISA benefits at issue here were paid after Dorothy’s death, and thus this case does not present the question whether ERISA would permit a nonparticipant spouse to obtain a devisable community property interest in benefits paid out during the existence of the community between the participant and that spouse.” 
  • Consensus after Boggs: The consensus of most commentators after Boggs can be summarized by the following: (i) because the decision did not address the effect of ERISA on qualified plan benefits paid out to the participant (husband) during the nonparticipant’s (wife) lifetime, those benefits should retain their community property character; consequently,  if benefits are paid from a qualified plan before the death of the nonparticipant spouse, then ERISA will not preempt the community property character of the distributed assets; (ii) if the benefits are paid from a qualified plan after the death of the nonparticipant spouse, then ERISA will continue to apply to the assets held in the IRA into which the assets are transferred; thus, ERISA will preempt state community property laws as to assets held in the IRA that were originally sourced in a qualified plan; and (iii) because ERISA governs qualified plans and not IRAs, state community property laws will continue to govern the creation, management and disposition of IRAs. Confused yet?
  • IRS: The Tax Code does not formally preempt state community property laws for IRAs. However, the Code does state in IRC 408(g), which governs IRAs, that it “is applied without regard to any community property laws.”
  • Judicial Interpretations and Exceptions: While these statutes and the Court’s Boggs decision would seem to resolve the question whether IRAs are subject to community property principles, several federal courts have joined the fray and essentially said ‘not so fast’ when it comes to ERISA’s preemption and state community property principles. For example the Ninth Federal Circuit Court held that because California’s community property laws ‘affect merely the ultimate ownership of distributed benefits’ there is no blanket preemption by ERISA. In that case, since the benefit at issue was a group life insurance benefit under an employee welfare plan and not a qualified retirement plan with joint and survivorship mandated benefits, the disputed death benefit was not subject to federal preemption and community property principles would be applied to determine who was entitled to the group life insurance death benefit. Emard, 153 F. 3d 949

Digging Deep into the Weeds: Like qualified plans,  IRAs are also at the intersection of state and federal law.

  • Federal Tax Law: IRC 408(a) says that an IRA must be a trust, although IRC 408(h) says that an IRA can be a custodial account under limited circumstances. The trust or custodial account must have a written governing instrument. In order to qualify as an IRA for federal tax (deferral) purposes, the governing instrument (trust or custodial agreement) must contain specific language and it must be administered in accordance with those required terms and conditions. The Code requires that that the account must be held for the ‘exclusive benefit of an individual or his beneficiaries.’ Nonetheless,  while these requirements are imposed by the federal government to constitute an IRA for income tax (deferral) purposes, state community property laws will still govern trusts and custodial accounts that are intended to qualify as IRAs. The qualification of the trust or custodial account as an IRA only affects their taxation.
  • State Property Law: Under the community property laws of most states  either spouse possesses the unilateral authority to manage and control community property. However that power does not extend to giving or selling community property without the spouse’s consent. Add to that the principle that the spouse acts with a fiduciary duty to the other spouse, that curbs even more the powers used by one  to manage and control community property. Thus, while a spouse can ‘roll’ their assets from a qualified plan to an rollover IRA without any fiduciary implications, the same cannot be said of assets that are contributed to an IRA in a community property jurisdiction from a spouse’s earnings, i.e. non-rollover assets used to fund the IRA.  Thus, state community property law will continue to control the management of the community property assets held in an IRA. In short, community property law will govern all trusts and custodial accounts that qualify as IRAs if that is where the IRA was established and to which contributions were made by a spouse.
  • Community Property Fiduciary Duty: As noted, while a spouse can unilaterally manage and control community property, that power does not include the power to gift or sell the community property without the other spouse’s consent. This fiduciary duty between spouses limits this unilateral ability to manage or control the community property asset, i.e. the IRA. But to follow this limitation in creating an IRA by rollover: (i) the IRA must be a trust or custodial account established with a fiduciary; (ii) the institution holds the transferred assets as a fiduciary for the transferor’s benefit- this transfer is not a gift by the transferor; (iii) similarly, to qualify as an IRA, the transferred assets must be held for the benefit of the transferor- meaning the transfer will not be a breach of the transferor’s fiduciary duty  to his spouse; and (iv) because ERISA preempts community property law- including community property remedies for a spouse’s breach of fiduciary duty, the transferring spouse should have no restrictions in his ability to fund an IRA with a rollover from his qualified plan account balance.
  • IRA Exclusive Benefit Rule: For the trust or custodial account to qualify as an IRA, the assets must be held for the ‘exclusive benefit of an individual or his beneficiaries.’ IRC 408(a). Add to this that the federal income tax laws that govern IRAs are applied ‘without regard to community property laws.’ IRC 408(g). “His beneficiaries” probably is interpreted to mean the beneficiaries of the owner-spouse, not the spouse who claims a community property interest in the assets. As a result, the IRA agreement only allows the IRA owner spouse to designate the beneficiary of the IRA, not their community property spouse. Thus, general trust principles will prohibit the trustee or IRA custodian from allowing the community non-owner spouse to designate a beneficiary in the owner-spouse’s IRA, applying general trust principles.
  • Taxation of IRA Distributions: Taxable distributions from an IRA are deemed under federal law to be separate property. Thus, taxable distributions from the IRA are separate property, even if the funds in the IRA account would otherwise be community property. The distributions are taxable to the person whose  name is on the IRA account. See IRS Publication 555, page 4. So the named owner of the IRA gets taxed on the income generated by the community spouse’s interest in the IRA.

Estate Planning Implications:

  • RMDs: A required minimum distribution is not affected by the community property rules. The RMD to the IRA owner is taxed to the IRA owner, using the IRA owner’s age,  whether or not the assets in the IRA are community property.
  • IRA Owner: Few problems arise for the IRA owner if the IRA holds community property. The owner is free to name whomever as beneficiary, per the IRA agreement. But if the IRA owner attempts to distribute his spouse’s community property interest in the IRA, serious legal problems can arise- see below. This is probably why we have at GLT a spousal consent provision in the standard IRA beneficiary designation, so that the spouse can consent to the disposition of his/her community property interest in the IRA. While that consent is not required for the beneficiary designation to be effective, it does not, technically speaking, address (or dispose?) of the spouse’s community property interest in the IRA.
  • Community Spouse: Estate planning becomes complicated when the community spouse wants to transfer her community property interest in her spouse’s IRA to a third person. Since the IRA owner only possesses the power under the IRA agreement to complete a beneficiary designation for the IRA, how does she dispose of her community property interest in the IRA? Normally by her Will. She could leave it to her spouse, which is probably the easiest solution, but she could also make a bequest of her share of the IRA to a third person under her Will. If the non-owner spouse uses a pour-over Will to a Trust, the pour over clause which covers the non-owner’s community property interest in the IRA might trigger an immediate income tax on the distributed amount, and possibly a 10% excise tax on an premature distribution under IRC 72(t)(1). This might be a situation where the spouses enter into an agreement where a waiver or consent to beneficiary designation is given by the non-owning spouse in exchange for an asset placed solely in the name of the non-owning spouse- a trade-off.

Recent Example:  A recent example of the confusion  between community property principles and IRA tax rules came last year in a private letter ruling, PLR 201623001. In that case the husband funded an IRA in a community property jurisdiction. Husband named the son from the marriage as the sole beneficiary of his IRA. Husband-father died. Wife filed a petition in the state probate court claiming that one half of the deceased husband’s IRA was her community property. The probate court awarded wife 50% of her late husband’s IRA, as it was clearly her community property; the court ordered the son to transfer that 50% amount to his mother. The son followed the probate court order. The IRS held: (i) IRC 408(g)  ignores community property principles; (ii) the son’s transfer of the 50% of his inherited IRA to his mother will be treated as a taxable distribution of the IRA to the son; (iii) the amount that the wife-mother received pursuant to the probate court order was not available to be rolled over by her into a spousal rollover IRA, as the funds came not from her deceased husband, but from her son (via a court order). From the son’s perspective, he lost not only the 50% of the IRA that his father wanted him to have, he also had to pay the income taxes on the transfer of the 50% of the IRA to his mother, meaning that the son ultimately received probably 30% of the IRA, not what his late father had intended.

Conclusion: 9 states use community property principles for married couples. While those community property principles do not apply to qualified plan accumulations, per Boggs, they may still apply to assets accumulated in an IRA, or which are rolled into an IRA from a qualified plan that had been established in a community property jurisdiction. While the IRA owner technically controls the assets held in the IRA, including the selection of beneficiaries of the owner’s IRA account, the owner’s spouse’s interest in the community property IRA do not disappear. In order to avoid the problems that appeared in last year’s PLR, it would make sense to obtain a spouse’s consent to a non-spousal beneficiary designation of the IRA, and since some, but perhaps not all of the assets held in the IRA originated in a community property jurisdiction, it is probably a good idea to obtain the spouse’s consent to that beneficiary designation. Admittedly this is a confusing area of the law, and red-flags should go up if you find yourself dealing with a retirement account, or IRA, that was created in a community property jurisdiction.