Kyle Young, First Vice President Investment Officer with the Accredited Domestic Partnership Advisor Designation, Wells Fargo Advisors, LLC in Short Hills, N.J., addresses the unique financial challenges faced by same-gender partners. This is the seventh article in a continuing series. Click here to watch his presentation from DiversityInc’s Innovation Fest!
June was a truly historic time for the LGBT community. With California’s Proposition 8 dismissed and a key section of the Defense of Marriage Act deemed unconstitutional, the financial- and estate-planning landscapes have drastically changed for “recognized” married LGBT couples.
With several current forms of relationship recognition for LGBT couples (marriages, civil unions and domestic partnerships) and with no laws in place to require recognition of out-of-state same-sex unions, the true impact of these decisions is largely yet to be determined. As the IRS and other federal agencies work through the nuances of implementing the rulings, we will begin to analyze what it really means to be a fully recognized, married, same-gender couple in the United States.
Several planning strategies and opportunities previously unavailable to married LGBT couples may be available now. For starters, there are many things to consider when it comes to the Traditional Individual Retirement Account, or IRA.
Spousal IRA Contributions
The general rule of thumb is that you must have earned income in order to make an annual IRA contribution. One caveat to this rule pertains to married couples. A spouse with earned income is permitted to fully fund his or her own IRA and make an annual IRA contribution on behalf of a nonworking/non-income-earning spouse. As more and more LGBT couples are building extended families, with potentially one spouse staying home to raise children, this new IRA-funding strategy is sure to have tremendous impact on overall retirement planning.
Penalty-Free Access to IRA Funds Prior to Age 59 1/2
Upon reaching age 59 1/2, an individual has the ability to take penalty-free distributions from his or her IRA. Distributions prior to age 59 1/2 generally incur a 10 percent early-withdrawal penalty. If the funds are used to cover certain expenses for you and/or your same-gender spouse, the penalty may be waived. These exemptions include payment of higher-education costs, medical-insurance premiums during periods of unemployment, unreimbursed medical expenses, and several others. The idea is that as half of a married couple, whether these expenses are incurred on your behalf or your spouse’s behalf, you now have penalty-free access to your IRA to cover the costs.
Tax-Advantaged Means of Splitting an IRA Upon Divorce
An unfortunate reality of marriage is that divorce is now something to consider. Although not often seen as a positive benefit of marriage, the formalized procedures of separating and splitting assets through the divorce process could be of great benefit to LGBT couples. In the past, there was no way to split certain assets on a tax-neutral basis because same-gender spouses were considered strangers in the eyes of the federal government and the IRS. In the event a couple separated and attempted to split assets, the only means of separating something like an IRA was to take a fully income-taxable distribution from the account and then gift the asset to the former spouse. That potentially made the exchange subject to both income and gift taxes. Now, recognized married couples have the option of splitting an IRA account using a formal divorce decree on a completely income- and gift-tax-free basis.
IRA Beneficiary Designations
Same-gender married couples will now have many more options available when inheriting Traditional IRA assets. Previously, if a surviving same-gender spouse inherited a Traditional IRA and chose to keep the funds in an IRA structure (through an Inherited IRA), he or she would be required to begin taking annual distributions in the year following the date of death. The options now are much more flexible and could lead to far greater planning opportunities. For example, a recognized spouse has the ability to defer annual distributions until either he or she reaches the age of 70 1/2 or the deceased spouse would have reached age 70 1/2, whichever is more advantageous. A surviving spouse also has the ability to consolidate inherited IRA funds into his or her own IRA, potentially reducing administrative costs and streamlining a portfolio.
As we await guidance on how the IRS and other federal agencies will define a “recognized married couple,” we should all continue to research how this newfound set of strategies may impact our individual situations. A planning meeting with your team of financial, investment and estate-planning advisors is definitely in order.
Wells Fargo Advisors is not a tax or legal advisor. Wells Fargo Advisors, LLC, member SIPC, is a registered broker-dealer and separate nonbank affiliate of Wells Fargo & Company, No. 25 in the 2013 DiversityInc Top 50.