Any experienced advisor knows the importance of advising a client to carefully choose, and regularly update, the beneficiary designations for his or her retirement accounts. The potential impact of state community property rules on these beneficiary designations may, however, be less than clear for some married clients who are concerned about the ultimate disposition of their retirement assets.
A recent IRS private letter ruling has brought this issue into the spotlight, highlighting the potentially unexpected results for surviving spouses in community property states when federal and state rules collide. If this ruling makes anything clear, it’s the importance of planning for the disposition of IRAs in community property states to avoid unpleasant surprises for clients who may be relying on their interests in those IRAs after the death of a spouse.
Community Property and IRAs
When a married couple lives in a community property state, income earned and property acquired during the marriage are generally treated as owned by both of the spouses. This means that, according to state law, one spouse may need the consent of the second spouse to name a third party as designated beneficiary of his or her IRA (although some beneficiary designation forms expressly provide for such consent).
Despite this, the state and federal rules in this area come into conflict when community property rules are involved. The Internal Revenue Code expressly provides that IRAs are separate property for federal tax purposes even if the assets would otherwise be deemed community property under state law. This means that distributions from that account are taxable only to the spouse who is the owner of the account, so that, in the case of divorce, the account owner is responsible for any taxes (or penalties) on IRA funds he or she withdraws to pay an ex-spouse (a trustee-to-trustee transfer can help avoid unexpected tax consequences in this situation).
In the case of death, the results can be similarly unexpected—especially for a surviving spouse who may be planning on the fact that his or her one-half community property interest in accounts funded during the marriage will be upheld.
State vs. Federal Rules: PLR 201623001
The conflict between the federal rules governing IRAs and state community property rules recently came to light in a private letter ruling that denied a surviving spouse’s community property interest in her deceased spouse’s IRA.
The taxpayer lived in a community property state with her spouse, who owned the IRA at issue. Her spouse died, designating the couple’s child as beneficiary of his IRA. After his death, the taxpayer filed a claim against her deceased spouse’s estate for her one-half interest in the community property she and her spouse owned (including the IRA).
A state court ordered that the IRA custodian assign the surviving spouse’s interest in the IRA to the surviving spouse in a spousal rollover transaction (a non-taxable event).
Despite this, the IRS relied upon IRC Section 408(g), which provides that community property rules must be disregarded for purposes of the IRA rollover rules, in order to find that the beneficiary designation controlled. As a result, the state court order contradicting this federal rule was ignored, meaning that if the named beneficiary (the taxpayer’s child) assigned any portion of the inherited IRA to the taxpayer, the transaction was entirely taxable—to the child, as IRA owner.
While all of the details are not shared in the PLR, it is entirely possible that the deceased spouse knew that he lived in a community property state and did not intend to disinherit his surviving spouse. It is reasonable to assume that he may have only intended to provide his portion of the IRA to their child, assuming his spouse would receive her one-half interest.
With proper planning, this result could have been achieved without the time and expense (and resulting tax liability) that were undertaken in this case.
Planning for the disposition of retirement accounts can be a complicated endeavor even in the absence of community property rules—but for those clients who live in community property states, taking these rules into account can be critical to avoiding conflict after the death (or divorce) of a married client.
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Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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