Overcoming the Boggs dilemma in community property states.

EXECUTIVE SUMMARY

* A participant spouse who has reached age 59 1/2 and whose pension plan permits in-service withdrawals may transfer funds from his qualified plan to an IRA to avoid ERISA's preemption of state community property laws.

* Alternatively, the participant spouse can create a promissory note in favor of the nonparticipant spouse in exchange for the latter's community property interest in all or a portion of the plan assets.

* Practitioners should carefully review their state's community property laws before preparing documents to complete the transactions proposed herein.

The Supreme Court's decision in Boggs v. Boggs disallowed the bequest of a nonparticipant spouse's community property interest in her participant spouse's pension plan; in community property states, this decision potentially wastes the applicable exclusion amount (AEA) ($650,000 in 1999) if the nonparticipant spouse dies first with insufficient assets to fully use the AEA. Part I of this article explained the issues; Part II discusses estate planning techniques that may allow the nonparticipant spouse to overcome the limits presented by Boggs.

Part I of this two-part article, in the August issue, explained the Supreme Court's decision in Boggs(20) and the negative consequences that could ensue if a nonparticipant spouse dies first. Part II, below, discusses planning techniques to avoid this result.

Alienation of Pension Plan Benefits

Another issue in planning to avoid the Boggs limitation is the alienation of pension plan benefits under Sec. 401(a) (13) (A); that section bars participants and beneficiaries from assigning, alienating and pledging their interests in qualified plans. As long as the participant spouse is alive, the nonparticipant spouse is neither a participant nor a beneficiary entitled to an interest in the plan. The relinquishment of the nonparticipant spouse's community property interest in the participant spouse's account is actually in accordance with Sec. 401(a)(13)(A), because it increases the participant's right to the account balance. Further, the arrangement does not provide for the payment of plan assets to anyone other than the plan participant, the person protected under Sec. 401(a)(13)(A).

The nonparticipant spouse's sale of his present community property interest in the plan assets is not an alienation or assignment of the plan benefits under Sec. 401(a)(13)(A). The participant has not assigned or alienated the plan benefits by gaining a greater interest in the plan assets. The beneficiary has not alienated or assigned any interest in plan benefits if he has not been changed. Yet, consideration has been given in exchange for the promissory note, because the nonparticipant spouse has surrendered a present ownership in the plan assets.

The nonparticipant spouse could still be the designated beneficiary of the retirement asset, to provide flexibility if the participant dies first. Alternatively, the nonparticipant spouse could agree to allow the participant spouse to change the beneficiary, provided the former is informed of any rights being relinquished (such as the right to the required statutory portion of a qualified joint and survivor annuity).

Examples

The following examples illustrate the merits of issuing a promissory note for a nonparticipant spouse's community property share of a participant spouse's pension:

Example 1--Community property state: X is married to Y; they live in a community property state and each is 50 years old. Their assets include a $350,000 house, $150,000 in miscellaneous assets and a $1,000,000 balance in X's employer's Sec. 401(k) plan. All of X's and Y's assets are community property; neither has any separate property. Each has the full $650,000 applicable exclusion amount (AEA) available.(21)

If X dies first, his share of the community property will be $750,000, one-half of the couple's $1,500,000 total assets. Under X's estate plan, $650,000 will pass to a trust for the benefit of Y (bypass trust), but will not be included in Y's estate at death. The remaining $100,000 in assets will pass to Y directly and qualify for the marital deduction.

If Y dies first, her share of the community property will also be $750,000, only $250,000 of which is outside of X's Sec. 401 (k) plan. The remaining $500,000 of her community property is invested in X's Sec. 401 (k) plan.

Under Boggs, a spouse who is not a participant in an Employee Retirement Income Security Act of 1974 (ERISA)-governed pension plan may not testamentarily dispose of a community property interest in undistributed pension funds. Thus, although Y has directed in her will that $650,000 is to pass to a bypass trust, her inability to dispose of the interest in the Sec. 401(k) plan allows her to pass only $250,000 to the bypass trust; the remaining $400,000 of the $650,000 AEA will be included in X's estate at death, X's estate will increase from $750,000 to $1,250,000; his estate tax will increase from $37,000 to $237,000.

Even if in-service distributions are allowed after age 59 1/2, X cannot roll over the funds in the Sec. 401(k) plan into an individual retirement account (IRA), because he is only age 50. Thus, before Y's death, X purchases her community property interest in his Sec. 401(k) plan by executing a $500,000 promissory note (from X, as maker, to Y, as payee). On Y's death, the promissory note and $150,000 in community property assets pass to the bypass trust established in Y's will to fully use the $650,000 AEA. All of Y's other community property assets pass to X and qualify for the marital deduction. On X's death, his estate will include Y's $500,000 community property interest in the Sec. 401(k) plan, because X purchased that interest with a promissory note; however, X's estate will be reduced by the unpaid amount of the promissory note under Sec. 2053.

Example 2--Common-law state: X is married to Y; they live in a common-law state and each is 50 years old. They own a $350,000 house as tenants by the entirety and $150,000 in miscellaneous assets as joint tenants with right of survivorship. X has a $1,000,000 balance in his employer's Sec. 401 (k) plan. Both X and Y have the full $650,000 AEA available.

X and Y agree that X's bypass trust will be named as beneficiary of a portion of X's interest in his Sec. 401(k) account. If X dies first, his bypass trust will be fully funded with $650,000 in assets. X's interest in the remaining assets will pass to Y and qualify for the marital deduction. On Y's death, $650,000 will be sheltered by her AEA; the remaining $200,000 of Y's estate will be subject to estate tax.

If Y dies first, the jointly owned property will pass to X by operation of law. None of Y's AEA will be used; her bypass trust will be totally unfunded. On X's death, the first $650,000 will qualify for his AEA; the remaining $850,000 will be subject to an estate tax liability of $344,500. Alternatively, X and Y could transfer all of their real and personal property to Y, allowing her to use $500,000 of her AEA by testamentarily transferring these assets to her bypass trust. Y's trust will still be underfunded by $150,000. On X's death, the first $650,000 will qualify for his AEA, leaving only $350,000 subject to an estate tax of $134,500.

X cannot execute a promissory note to Y for her interest in the Sec. 401(k) plan, because Y has no current state property interest in the pension funds; thus, she will not be able to fund her bypass trust with a promissory note. X's heirs will not be able to deduct the promissory note claim from X's estate. Additionally, even if in-service distributions are allowed after age 59 1/2, X is only 50. Thus, there is no way to use X's retirement funds to fund Y'S bypass trust if she dies first.

Moving Funds from a Sec. 401 (k) Plan to an IRA

No Preemption

In Boggs, the Supreme Court held that ERISA preempts the testamentary disposition of a community property interest in undistributed pension funds. The Court did not decide whether ERISA would permit a nonparticipant spouse to obtain a devisable community property interest in benefits actually paid out during the existence of the community between the participant and the spouse.

Sec. 401(k)(2)(B)(i)(III) prohibits pension funds from being distributed to participants or beneficiaries before the participant reaches age 59 1/2. Once the participant has attained age 59 1/2, he may transfer funds from a Sec. 401(k) plan to an IRA tax-flee, under Sec. 402(c)(3). If funds are transferred to an IRA, ERISA will no longer apply to preempt state community property laws.

Planning

To fully use the nonparticipant spouse's community property interest in the participant's pension plan, the pension funds should be rolled over into an IRA account. The nonparticipant spouse and the participant spouse should simultaneously enter into an agreement under which the IRA would be divided between them in a tax-advantaged way. A portion of the IRA account should be allocated to the nonparticipant spouse as needed to fully use the nonparticipant spouse's AEA. After the division, each party's share is separate property. The agreement should not involve any actual distribution of amounts from the IRA to the nonparticipant spouse or the nonparticipant spouse's IRA.

In Letter Ruling 9439020,(22) a couple agreed to divide the husband's IRA (community property) into separate, equal shares that could be disposed of separately by each spouse. The Service ruled that the agreement did not result in a gift to the wife. The value of the separate interest held by each spouse after the division equaled the value of each individual's community interest before the partition. Additionally, the agreement did not constitute a distribution or transfer of amounts from the IRA for income tax purposes. Therefore, no amount was includible in either individual's gross income under Sec. 408(d)(1), because the reclassification of community property into separate property is not an actual distribution or payment from the IRA.

The right of a nonparticipant spouse to designate the beneficiaries of her portion of her participant spouse's IRA is further supported by Est. of MacDonald,(23) a California Supreme Court case. The husband had created three IRAs funded with rollovers from an employer plan and named his revocable living trust as beneficiary. As required by the IRA adoption agreements, his wife consented to the designation of the trust as beneficiary. After the wife's death, her executor claimed a community property interest in the IRAs. Although the husband admitted that the plan distribution that was rolled over into the IRAs was community property, he argued that the wife's consent to the designation of the revocable trust as beneficiary was a waiver of her community interest. The California Supreme Court agreed with the executor; it determined that the spousal consent was not an express declaration to transmute the community property into separate property.

Partitioning an IRA

Example 3--Community property state: X is married to Y; they live in a community property state and each is 60 years old. Their assets include a $350,000 house, $150,000 in miscellaneous assets and a $1,000,000 balance in X'S employer's Sec. 401(k) plan. All of X's and Y's assets are community property; neither has any separate property. Both X and Y have the full $650,000 AEA available.

X and Y agree that the Sec. 401(k) plan assets should be used to ensure that a bypass trust will fully use the AEA. If X dies first, his share of the community property will be $750,000, one-half of the $1,500,000 in assets the couple owns. The first $650,000 of X's assets will pass to a bypass trust for the benefit of Y, but will not be included in Y's estate at death. The remaining $100,000 in assets will pass to Y and qualify for the marital deduction.

If Y dies first, her share of community property will also be $750,000. Only $250,000 of Y'S community property is outside of X'S Sec. 401(k) plan; the remaining $500,000 is invested in X'S Sec. 401(k) plan.

Under Boggs, a spouse who is not a participant in an ERISA-governed pension plan may not testamentarily dispose of a community property interest in undistributed pension funds. Thus, although Y has directed in her will that $650,000 in assets are to pass to a bypass trust, her inability to dispose of the Sec. 401(k) plan interest allows her to pass only $250,000 in assets to the trust. Y will not be able to use the remaining $400,000 of her $650,000 AEA; it will be included in X's estate at death and increase his estate taxes from $37,000 to $237,000.

If the Sec. 401(k) plan allows in-service distributions after age 59 5,2, however, X could roll over the $1,000,000 plan balance into an IRA (which is not governed by ERISA). X and Y could then enter into an agreement partitioning the IRA under state community property laws, so that each would own one-half of the IRA ($500,000) as separate property. On Y's death, her share of the remaining undistributed IRA will pass to a bypass trust to fully use the $650,000 AEA. All other Y community property assets pass to X via the marital deduction. On X's death, his estate will include only his community property interest in the remaining undistributed IRA.

Example 4--Common-law state: X is married to Y; they live in a common-law state and each is 60 years old. They own a $350,000 house as tenants by the entirety and $150,000 in miscellaneous assets as joint tenants with right of survivorship. X has a $1,000,000 balance in his employer's Sec. 401(k) plan. Both X and Y have the full $650,000 AEA available.

X and Y have agreed that if X dies first, his bypass trust will be funded with $650,000 from his Sec. 401(k) plan; his remaining property will pass to Y and qualify for the marital deduction. On Y's death, $650,000 will pass to a bypass trust; the remaining $200,000 of Y's estate will be subject to estate tax.

If Y dies first, her property will pass to X by operation of law; thus, her bypass trust will be totally unfunded. On X's death, the first $650,000 of assets will qualify for the AEA; the remaining $850,000 will be subject to an estate tax liability of $344,500. Alternatively, X and Y can transfer all of their real and personal property to Y; she could fund the bypass trust with $500,000 ($150,000 short of full funding). On X's death, the first $650,000 of assets will still qualify for the AEA, leaving only $350,000 subject to an estate tax of $134,500. Depending on X's and Y's marginal income tax bracket (and assuming X can take an in-service distribution from his Sec. 401(k) plan), he could withdraw funds and give them to Y to fully fund the bypass trust. The withdrawal, however, would be subject to current income taxation.

Because this is a common-law state, Y does not have any state property interest in X's Sec. 401(k) plan balance or in his IRA. Consequently, there is no incentive to take an in-service distribution from the Sec. 401(k) plan and roll it into an IRA.

Conclusion

Boggs imposes severe limitations on the estate planning available to married couples residing in community property states. When their primary asset is one spouse's pension plan, the participant spouse could have a significantly larger estate than is necessary. Additionally, the nonparticipant spouse may not be able to transfer his community property interest in the pension plan by testamentary disposition.

To eliminate this problem, a participant spouse who has reached age 59 1/2 and whose pension plan permits in-service withdrawals may transfer funds from his qualified plan to an IRA to avoid ERISA's preemption of state community property laws. If this approach is not available, the participant can create a promissory note in favor of the nonparticipant spouse in exchange for his community property interest in all or a portion of the plan assets. The note creates a claim against the participant's estate that is deductible under Sec. 2053.

With careful analysis and execution of these planning techniques, significant tax savings can be obtained for the estate of the pension plan participant. Practitioners should carefully review their state's community property laws before preparing documents to complete the transactions proposed in this article.

(20) Sandra Jean Dale Boggs v. Thomas F. Boggs, 117 S.Ct. 1754 (1997), rev'g 82 F3d 90 (5th Cir. 1996).

(21) For simplicity's sake, the 1999 AEA of $650,000 is used in the examples in this article.

(22) IRS Letter Ruling 9439020 (7/7/94); see Kasner, "New Ruling Raises Issues of Community Property Rights in IRAs," 83 Tax Notes 1753 (6/21/99).

(23) In re Est. of Margery M. MacDonald, 794 P2d 911 (Cal. 1990).

Marjorie A. Rogers, Esq. Sutin, Thayer & Browne, PC Albuquerque, NM

Eric C. Christensen, Esq. Sutin, Thayer & Browne, PC Albuquerque, NM

Carol Mayo Cochran, CMA, CEBS, CPA Rogoff, Erickson, Diamond & Walker, LLP Albuquerque, NM

For more information about this article, contact Ms. Rogers at [phone] or Ms. Cochran at [phone]