An individual retirement account is generally considered community property if you live in one of the nine states that have community property laws. Generally, that means each spouse owns half of the IRA. Classification as community property is important because it causes the property to be divided equally upon divorce. However, the manner in which IRA funds and distributions are classified depends on the specific laws of your community property state, as well as when IRA funds were earned and distributions occur. Community property states are in the minority in the United States; most states follow a different legal scheme when dividing a couple's property in a divorce.
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Community property is a property division system followed in Arizona, Idaho, California, Texas, New Mexico, Nevada, Louisiana, Wisconsin and Washington. In a community property state, each spouse has the right to half of the property that either earns during the life of the marriage, known as "community property." However, a spouse gets to keep her own separate property, property she earned before the marriage and gifts and inheritances received during the marriage. However, if the spouse's separate property earns income during the marriage, that income may constitute community property. Community property is divided 50/50 upon divorce; if a spouse dies, she has the right to bequeath her half of the community property as she pleases.
IRAs During Marriage
Community property states generally consider the portion of an IRA earned during marriage to be community property. Therefore, if spouses begin to receive IRA distributions from IRA earnings made during the marriage, the Internal Revenue Service treats those distributions as taxable community property income under the Internal Revenue Code. When one spouse decides to reclassify his separate property IRA as a joint, marital IRA, converting the IRA into community property, the IRS doesn't consider this a taxable distribution. However, if the spouse transfers his community property half of the IRA into a separate property IRA, the IRS will consider it a taxable distribution.
Effect of Divorce
If a couple divorces in a community property state, the court will look at the IRA and decide what percentage of the funds were earned during the marriage. To do so, the court will generally compare the period of the marriage against the entire period over which the IRA was earned. The percentage of the IRA that corresponds to the marital period will be considered community property, while the balance will typically be the separate property of the earning employee. Couples may choose to divide up the marital IRA by rolling it over into two separate IRAs; such IRA transfers, made according to a divorce decree, are not considered taxable transfers by the IRS.
Changing the Default
The 50/50 division of a community property IRA is the default. However, this division can be changed by a premarital contract which specifies how the couple will divide the IRA in the event of divorce. A couple may also choose to change the default community property division by incorporating the IRA into their estate plan. For instance, the couple may place the IRA in a living trust, with their children as the beneficiaries. In this case, upon the death of one spouse, both halves of the community property would simply remain in the trust.