When Is an IRA Considered Community Property?

An Individual Retirement Account (IRA) is a tax-advantaged savings plan that individuals establish separately from any employer-sponsored retirement plans. The funds benefit from either tax-deductible contributions or tax-free withdrawals, depending on the account type.

Community property is a legal framework where most assets acquired during a marriage are owned equally by both spouses. This system applies in the following states:

• Arizona
• California
• Idaho
• Louisiana
• Nevada
• New Mexico
• Texas
• Washington
• Wisconsin

A few other states have elective community property laws, allowing couples to opt into the system.

Determining the Character of IRA Funds

The classification of IRA funds as either community or separate property depends on when and how the contributions were made. Contributions made to an IRA during a marriage using income earned by either spouse are presumed to be community property. This means that even if the IRA is in one spouse’s name, the other spouse has a legal ownership interest in the portion funded with marital earnings, including the appreciation generated by these contributions.

Conversely, funds can be classified as separate property. Contributions made to the account before the marriage are considered the separate property of the account holder. Similarly, if funds from a separate source, like an inheritance or a gift to one spouse, are deposited into an IRA, those funds and their growth retain their character as separate property.

A challenge arises when separate and community funds are mixed within the same IRA, a situation known as commingling. When this occurs, the spouse claiming a separate property interest has the burden of proof. They must definitively identify the separate portion through a process called tracing, which requires clear documentation like pre-marriage statements or inheritance records. Without this evidence, the entire commingled account may be treated as community property.

Calculating the Community Property Interest

When an IRA contains both separate and community funds, courts use a pro-rata formula to determine the portion of the IRA that belongs to the marital community. This calculation ensures a fair apportionment of the asset’s growth. The formula multiplies the IRA’s total value at the time of division by a fraction where the numerator is community contributions and the denominator is all contributions.

For example, an individual had an IRA with a balance of $50,000 at the time of marriage. During the marriage, the couple contributed an additional $50,000 from marital earnings. If the total value of the IRA at divorce is $200,000, the calculation begins by identifying total contributions of $100,000 ($50,000 separate + $50,000 community).

The community property portion is then calculated as $200,000 (current value) multiplied by ($50,000 community contributions / $100,000 total contributions), which equals $100,000. This $100,000 represents the community property share, which is then divided equally between the spouses.

IRA Division in a Divorce

For federal income tax purposes, the IRS treats an IRA as the separate property of the spouse whose name it is under, meaning distributions are normally taxable only to the account owner. A special process is required to divide the asset in a divorce without creating a taxable event.

IRAs are not divided using a Qualified Domestic Relations Order (QDRO), as QDROs are exclusively for employer-sponsored retirement plans like 401(k)s. The correct method for dividing an IRA is a “transfer incident to divorce.” This process must be detailed in the divorce decree or a related marital settlement agreement.

The document should state the amount or percentage of the IRA to be transferred and identify the accounts involved. The transfer is executed as a direct trustee-to-trustee transfer, where funds move from the original owner’s IRA directly into an IRA for the receiving ex-spouse.

When executed correctly, this transfer is a non-taxable event. The original account owner does not pay income tax or the 10% early withdrawal penalty on the funds. If the process is handled incorrectly, such as by withdrawing cash and handing it to the ex-spouse, the original owner could be liable for both income taxes and penalties.

IRAs and Community Property at Death

Community property law also affects IRAs upon the death of an account owner, which can create a conflict between the named beneficiary and the surviving spouse’s rights. In community property states, a surviving spouse has a legal claim to one-half of all community assets, including the portion of an IRA funded during the marriage.

The beneficiary designation on an IRA does not automatically override a surviving spouse’s state law property rights. To name a non-spouse beneficiary for the entire IRA, the account owner must obtain a written waiver from their spouse relinquishing any community property claim.

Without this formal consent, the surviving spouse may have a legal claim to 50% of the community portion of the assets, regardless of who is named as the beneficiary. This can lead to legal disputes where the surviving spouse must assert their claim against the named beneficiary.

Without a valid waiver, an IRA custodian may freeze the account if a dispute arises, pending a court order. This highlights the importance of aligning beneficiary designations with community property laws to ensure a clear transfer of assets.