Community Property States “Tax Traps”

Generally there are two systems of property in the US. Most states use the common law system, but about 30% of Americans live in states that operate under Community property laws. .Specific laws vary among the nine “Community Property” states. However, the basic concept of those laws is that a husband and wife each own a 50% interest in what is labeled community property. One determining factor in the classification of a particular asset as community property is the time of acquisition.

Community property is usually defined as everything a couple owns that was acquired during the marriage, excluding “separate property” owned by either of them individually. Separate property is generally defined as that property which each person brings into the marriage, plus anything that either spouse acquires by inheritance during the marriage. Beware that there are other “wrinkles” that can complicate that general definition. 

The nine Community Property states are AZ, CA, ID, LA, NM, NV, TX, WA and WI.

Here’s the potential “tax trap” for beneficiaries of retirement plans.

When you mix community property rules with retirement plan rules (401K, 403B, IRAs, etc.), a problem… can find YOU. Clients and/or advisors must understand how the two sets of tax rules interact.

The basic problem stems from the fact that the IRS considers an IRA as separate property, even if the couple lives in a community property state. The IRS says that Joe owns his IRA… and Sue owns hers.

The laws can be complicated (and Supreme Court rulings), but depending upon whether the retirement plan is passing from death or divorce and if it’s an IRA or 401K-type plan there could be different potential issues.            

Nationally known IRA expert, Ed Slott, CPA says: “When it comes to determining who gets the retirement plan funds after the death of a spouse or a divorce, community property rules can come into play. Because community property law can dictate who gets the IRA after death, it must be taken into account when you name a beneficiary of an IRA.” (The rules may be different with a 401K-type plan).

In death, if the spouse is the only primary beneficiary there is no problem in all 50 states. But problems can arise if that is not the case. In a divorce, those living in a community property state should divide the any 401K-type (ERISA) retirement plans using a QDRO (Qualified Domestic Relations Order) while an IRA should get a court order and have a trustee to trustee transfer in order to avoid any potential and unwanted tax issues.

And one more thing to know – perhaps the one that applies to everyone no matter what state you live in:

Retirement accounts pass at death based solely on the latest beneficiary form the custodian has on file – NOT what is stated in a will or trust. Beneficiary forms always trump bequests made in a will. Have you updated your retirement plan beneficiaries if your life has changed since the account was opened (divorce, loss of a child, etc.)?

And of course, I need to remind you that I am not a lawyer (never have been or will be) and cannot and do not offer any legal advice.

All the best…Mark