Estate Planning Considerations in Community Property States Relating to Retirement Accounts

“Estate Planning Considerations in Community Property States Relating to Retirement Accounts,” that is the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow Natalie Perry of Chicago.

Community property rules can quietly reshape how retirement accounts are owned, inherited and taxed, often in ways couples don’t expect until it’s too late. In this podcast, we unpack how living in a community property state affects IRAs, 401Ks and other retirement accounts, why beneficiary designations matter more than most people realize and where estate plans commonly go sideways.

ACTEC Fellow Karen Gerstner of Houston, Texas will highlight the nuances for planners and what to keep in mind when designating beneficiaries. Welcome Karen.

Karen Gerstner:  Thank you, Natalie. Today I’m going to focus on community property aspects of planning for retirement accounts. And my focus is on the 9 traditional community property states, which are Louisiana, Texas, New Mexico, Arizona, Nevada, California, Washington, Idaho, and Wisconsin. And of course there are some differences between the community property states, but I’m going to be providing some general rules that apply in most, if not all, of the community property states.

I think a difficult thing for people in common law states and people who aren’t even attorneys to understand is there’s significant difference between community property law and the marital property law and the common law states and how this affects estate planning.

One difference is when spousal rights arise. In a community property state, both spouses own equal undivided vested community property interests and the community property assets as soon as those assets are acquired during the marriage. Whereas in the common law states, the spousal rights issues don’t really arise until the marriage terminates by death or divorce. And this does affect how we plan with retirement accounts.

Community Property vs. Common Law: Why It Matters for Retirement Accounts

The other big difference is title. In a community property state, the title of a particular account or other asset does not indicate the owner of the asset. In Texas, for example, we have sole management community property. The asset itself is community property, but it’s titled in the name of just one spouse, which is what happens with retirement plans, but that spouse is just the manager of that asset on behalf of both spouses. The spouse who is the titled owner of a community property asset owes fiduciary duties to the other spouse and must take into account the other spouse’s community property ownership interest in that asset when managing that asset as the sole titled owner. So, we don’t want to get caught up in title indicating who owns the particular asset because that is not true in most community property states.

Title Does Not Equal Ownership in Community Property States

Even in a community property state, a particular spouse can own separate property. And, in general, this is going to be assets that were acquired prior to the marriage or assets acquired during the marriage by gift, devise, or dissent. But we’ll see how one particular issue can change what started as one spouse’s separate property into community property. And this has to do with income that is earned by the assets during the marriage.

In all of the community property states, if a particular asset is community property, then the income earned by that asset during the marriage is also community property. But 4 of the traditional community property states — Texas, Louisiana, Idaho, and Wisconsin — have a rule regarding income earned by separate property assets during the marriage. So, let’s suppose one spouse owns a retirement plan prior to the marriage or inherits a retirement plan from a parent. Initially, that retirement plan will be the separate property of that spouse. But what if that retirement plan earns any income or has any income added to it during the marriage? In those 4 community property states that I mentioned, income from separate property during the marriage is community property. So you have a commingling within a particular account of the original separate property portion and now the added community property income. And this can make it very difficult to deal with commingled assets.

Separate Property, Income, and the Commingling Trap

One way around this problem is for people about to marry or married couples, domiciled in a community property state, is to enter into some sort of marital property agreement. This comes up a lot with inherited IRAs, where both spouses might inherit an IRA from a parent and they live in one of the 4 community property states that has the rule that income during the marriage from separate property is community property. Those spouses can have a simple marital property agreement that the income earned inside their inherited IRA will be separate property and that will solve that commingling problem.

Using Marital Property Agreements to Prevent IRA Problems

But let’s talk about completing beneficiary designation forms because we are focusing on retirement accounts. And retirement accounts are in a category that I call “beneficiary designation assets.” These are assets that are transferred at death by the applicable beneficiary designation form. So, we might have these assets payable to a trust, for example, but it is the beneficiary designation form itself that initially transfers the asset away from the deceased owner to the beneficiary.

Why Beneficiary Designation Forms Control Retirement Accounts

When we’re dealing with a community property retirement account, again, only one spouse will be the titled owner or the participant. And I might use the term participant to refer to both the employee or retiree who was participating in a qualified plan and the titled owner of the IRA. But let’s suppose that this qualified plan or IRA is accumulating while the participant and his spouse are living in a community property state. So, this particular retirement plan or IRA is community property.

We know that only the participant has the right to complete the beneficiary designation form for that retirement plan or IRA. So the participant needs to consider that this plan or IRA is a community property asset owned equally by both spouses. The minimum thing that participant needs to do when completing the beneficiary designation form is to name the spouse as a 50% primary beneficiary of the plan or IRA, and that way, the participant is taking into account the ownership interest of the other spouse.

Naming the Spouse: The 50% Minimum Rule in Community Property States

Of course, the participant can name the spouse as the 100% beneficiary, which is fine. You just can’t have the participant naming someone other than the spouse as a beneficiary of more than 50% of that retirement plan because that means the participant is disposing of not just his interest in the plan or IRA, but also the spouses.

And this came up in a case I had where the financial advisor recommended that the participant name his grandchildren as the primary beneficiaries of his IRA instead of naming his spouse to receive any part of the IRA. And this was before the Secure Act when those grandchildren would have had very long stretch IRAs because of their life expectancy. But I pointed out the problem with that is the participant was also disposing of his spouse’s community property, one half interest in the IRA upon his death. And if the spouse didn’t challenge that, she would be making a gift of her half of that IRA to the grandchildren on her husband’s death, which is not a good result.

We do have this challenge coming up in these type of cases in Texas where the spouse can allege fraud on the community, that one spouse is fraudulently giving away the other spouse’s community property interest. It’s an equitable claim that doesn’t always work though, because the court is going to be looking at what other assets that deceased spouse might be leaving to the surviving spouse and what other assets the surviving spouse actually owns. But this puts a spouse in this situation in a horrible position of having to dispute the beneficiary designation after the deceased spouse’s death to claim her community property ownership interest because if she doesn’t dispute it, then she really is making a gift.

Qualified Plans vs. IRAs: Understanding the Boggs v. Boggs Distinction

Now we have to look at the other side of this. The other side of this differs depending on whether you’re talking about a qualified plan or an IRA. And by the other side, I mean the community property ownership interest of the non-participant spouse in the plan or IRA titled in the name of the participant spouse. We know that in the case of a qualified plan, the non-participant spouse, if she dies first, has no right to dispose of any interest in the participant’s qualified plan. That is Boggs v. Boggs. We don’t need to interpret Boggs v. Boggs as saying that the participant’s qualified plan is his separate property, there’s no need to go that far. This is simply federal preemption, ERISA, overstate community property law in the case where the non-participant spouse happens to die before the participant.

• But that rule in Boggs does not apply to IRAs. And in the case of a lot of older clients, they’ve already separated from service or otherwise retired and rolled over their qualified plan to an IRA rollover. Again, IRAs, including IRA rollovers, are not subject to the Boggs rule.

So now, again, we have the death of the participant. And, in that case, it’s just a matter of the participant making sure that he has named his spouse as at least a 50% beneficiary of the IRA because we don’t want to cause that gift problem for the surviving spouse.

But what if the non-participant spouse dies first? In Texas, we have a Texas Supreme Court case that says that the non-participant spouse disposes of her community property interest in the participant’s IRA by will, if she has one. If she dies without a will, then it’s by intestacy. In other words, the Texas Supreme Court says that the non-participant spouse’s interest in the IRA titled in the participant’s name is a probate asset. So, in Texas at least, lawyers who are writing a will for the non-participant spouse are going to include a provision in the non-participant spouse’s will, leaving her community property one half interest in the IRA titled in the participant’s name.

Considerations for Non-Participant Spouse: Probate and Co-Ownership Risks

If we focus on what the non-participant spouse has to do to dispose of her community property interest in an IRA titled in the participant’s name, we are going to be looking at a provision in the non-participant spouse’s will in which she makes a specific gift to the participant of her community property interest in all IRAs titled in the participant’s name. Thus, when the non-participant spouse dies, she is leaving her 50% ownership interest in the IRA to the surviving spouse who has been the titled owner, but who in fact has not been the 100% owner until that gift from the non-participant spouse on her death.

If the non-participant spouse does not leave her community property interest to the surviving spouse and it goes to someone other than the surviving spouse, perhaps children or even a trust for the spouse. Now you’ve got a co-ownership of the IRA after the death of the non-participant spouse between the participant who owns the 50% community property interest he owned before his spouse died, and the beneficiary or beneficiaries of the non-participant spouse who received the non-participant spouse’s community property interest on her death.

We used to do this on purpose in the 80s and 90s because the estate tax exclusion amount was so low, the estate tax rate was so high, and the most valuable asset that many couples owned was an IRA rollover in one spouse’s name, so we had agreements between the beneficiaries who were receiving the non-participant spouse’s community half of the IRA and the surviving spouse who owned the other half. And this had to cover distributions during the surviving spouse’s life, the payment of income taxes on the distributions, the beneficiary of that IRA because it was a co-owned IRA. In short it was a pretty messy situation that we abandoned as soon as we got a higher estate tax exclusion amount and no longer needed to try to exclude half of an IRA from estate taxes. But it can happen by accident when people don’t specifically deal with a non- participant spouse’s community property interest in IRAs titled in the participant’s name, and of course there could be a more global agreement where the beneficiaries of the non-participant spouse’s community property one half interest agree that that interest will be owned by the participant’s spouse and in exchange the beneficiaries of the non-participant spouse will receive other assets.

But there’s all kinds of tax implications, there might not be tax implications if it’s a highly contested matter where there is consideration, but you’ve always got to worry about transfers of IRAs and acceleration of income taxes. I will say that the IRA custodians, if they’re not involved they don’t even think of the fact that the non-participant spouse owned a community property interest, as far as they’re concerned the IRA is still owned 100% by the participant after the death of the non-participant spouse, but the better approach is during planning discuss these retirement plan issues with a couple in a community property state. It may be that the spouses want to do some sort of marital property agreement and make the IRA titled in the husband’s name, for example, the husband’s separate property and make the IRA titled in the wife’s name the wife’s separate property.

That is something that we do quite often and there may be other assets involved in the partition if the IRAs are not of a similar size or value, but in short it’s not that simple when an IRA is community property and even though we have the Boggs case that addresses the non-participant spouse’s interest in a qualified plan the Boggs case does not address what happens if the participant dies first, so even with a qualified plan the participant has to be careful how the beneficiary designation form is completed for that plan taking into account the spouse’s community property ownership interest.

The Retirement Equity Act and Spousal Consent Requirements

Keep in mind that the Retirement Equity Act provides that with respect to a qualified plan the participant must name his spouse as the beneficiary. Now the spouse and the participant can wave and consent so that that requirement doesn’t apply, but if that requirement is observed then there’s not going to be a problem with community property law because the surviving spouse will be receiving not only her own half but the deceased participant’s half of the qualified plan.

Natalie Perry:  Thank you, Karen, for that informative presentation. For more information on community property please visit ACTEC Trusts and Estate Talk podcasts.

You may also be interested in

• Migrating Clients from Common Law to Community Property States (and Vice-Versa) (Sept 2022)
• Gifts to Married Beneficiaries Living in Community Property States (Dec 2020)

A video resource to share with your clients

What is Community Property?  Understand what community property is, how it affects assets such as a home or a business, what quasi-community property is, and more.