Is an ex-spouse entitled to an IRA after divorce?

When it comes to handling retirement accounts after a divorce, there’s one tip I cannot stress enough: Check the beneficiary forms!

I see it time and time again. After a divorce, a client forgets to update his or her beneficiary form, leaving the ex-spouse as a beneficiary. No one notices this error until, of course, the spouse with the IRA or other assets dies. Then the real mess begins, often ending up with the ex-spouse receiving the property even though that was not the intention.

Advisors already know that this nightmare can be avoided simply by updating beneficiary forms after life events like a divorce, but it is still often missed until it’s too late.

HARUYOSHI YAMAGUCHI/BLOOMBERG NEWS

So here we go again with another long court battle because this issue wasn’t addressed. This time, though, the U.S. Supreme Court weighed in. In this case, the property was a valuable life insurance policy and the case slogged on for seven years.

Can you imagine how clients might feel not being able to know whom the beneficiary will be all that time? What if the funds are needed immediately? What will you tell clients? Would you want this kind of transaction left up to the courts to decide? Advisors have a lot to learn from this case.

In the case of Sveen v. Melin, U.S. Supreme Court, No. 16-1432, decided on June 11, 2018 the Supreme Court ruled overwhelmingly (8-to-1) that life insurance proceeds would not go to an ex-spouse, even though her name remained on the beneficiary form after the divorce. Instead, the Supreme Court said the Minnesota state statute removing an ex-spouse as a beneficiary upon divorce is constitutional and awarded the life insurance proceeds to the contingent beneficiaries, who in this case were children from a prior marriage.

Although this was a life insurance case, it could equally impact IRA beneficiaries after a divorce.

The story began back in 1997 when Mark Sveen and Kaye Melin tied the knot. The next year, Mark purchased a life insurance policy. He named Kaye as the primary beneficiary and his two children from a prior marriage as contingent beneficiaries.

Mark and Kaye divorced in 2007. Their divorce decree made no mention of the life insurance policy, although it did award Kaye both their snowmobile and all-terrain vehicle. Mark never took any action to update or change the beneficiary on his life insurance policy. He died in 2011 and at the time of his death, ex-wife Kaye remained the primary beneficiary.

In 2002, Minnesota amended its state probate code, applying its revocation-upon-divorce statute to life insurance beneficiary designations.

The statute provides that if one spouse names the other on a beneficiary designation form for a non-probate asset, such as a life insurance policy, their divorce automatically revokes that designation. The funds instead go to the contingent beneficiary.

After Mark’s death, the children made a claim for his life insurance proceeds. They argued that the Minnesota statute revoked the designation of Kaye as the life insurance beneficiary when she and Mark divorced and that the proceeds should instead be paid to them as contingent beneficiaries.

Kaye argued that she was entitled to the funds because the statute was not enacted until 2002 and Mark purchased his life insurance policies in 1998. She argued that to apply a statute that did not exist in 1998 would be unconstitutional.

The insurance company filed an interpleader to establish whether the revocation-upon-divorce statute nullified this designation. The battle over life insurance proceeds between Kaye and her former stepchildren began in the District Court, went to the 8^th Circuit Court of Appeals and ended up in the Supreme Court.

What the court said: The Supreme Court held that the Minnesota statute revoking the ex-spouse as the beneficiary of the life insurance upon divorce is constitutional and that the life insurance proceeds should be paid to the contingent beneficiaries, his children.

The court did not agree with Kaye’s contention that the retroactive application of the Minnesota statute violates the contracts clause of the Constitution. Justice Kagan wrote the opinion of the majority, which starts with an explanation of the contracts clause. Simply put, the contracts clause restricts the power of the states to interfere with or disrupt contractual arrangements.

To determine if a law crosses the constitutional line and violates the contracts clause, the court has developed a two-step test. Step one asks whether the state law has “operated as a substantial impairment of a contractual relationship.” The court never got to the second step because three aspects of Minnesota’s law, when considered together, defeated Kaye’s argument that the law “severely impaired” her ex-husband’s life insurance contract.

First, the Minnesota statute is designed to reflect a policyholder’s intent. The intent of most individuals after a divorce would be to disinherit their ex-spouse. The court stated “…the insured’s failure to change the beneficiary after a divorce is more likely the result of neglect than choice.”

Second, the law is unlikely to disturb any policyholder’s expectations at the time the contract was signed. The court noted that it is unlikely people are thinking much about divorce when they purchase a life insurance policy and if they do think about it, it is unlikely they can predict what will happen to the policy.

And third, the statute merely provides a default rule. It only applies if a policyholder does not update the beneficiary form. If the policyholder did update the form, nothing in the law would stop him from going ahead and renaming an ex-spouse after a divorce.

Justice Gorsuch was the lone dissenter. According to Gorsuch, the Minnesota law interfered with private contracts too much to pass constitutional muster.

Interestingly, Gorsuch and several women’s rights legal groups found themselves on the same side of this legal dispute. Several of them filed a brief with the Supreme Court arguing that state statutes, such as Minnesota’s, harm women. Statistically, women are less likely to own assets like life insurance policies or IRAs and are more likely to have their retirement security threatened by laws that automatically remove a beneficiary upon divorce.

Andrew Harrer/Bloomberg

What does the ruling mean for other states? Well, Minnesota is not alone in enacting a law which revokes beneficiary designations upon divorce for all sorts of non-probate assets. Currently there are 25 more states that have such statutes on the books. While these laws do vary a bit from state to state, this ruling by the Supreme Court means that for the most part, state statutes revoking beneficiary designations are here to stay.

What about IRAs? This ruling could apply to IRAs, 401(k)s and other retirement accounts.

The Court says this ruling applies to “similar” assets which could mean IRAs, as well. According to the Court, “under the statute, if one spouse has made the other the beneficiary of a life insurance policy or similar asset, their divorce au­tomatically revokes that designation so that the insurance proceeds will instead go to the contingent beneficiary or the policyholder’s es­tate upon his death.”

The Lazar Case: While the Sveen case dealt specifically with a life insurance policy, state statutes that revoke beneficiary designations upon divorce can affect IRAs. Just as the ex-spouse was removed as the life insurance beneficiary in the Sveen case, an ex-spouse who was named as an IRA beneficiary could be removed by a state statute.

In the case of Lazar v. Kroncke, Case No. 15-15078, filed on July 14, 2017 in 9th Circuit Court of Appeals, the 9^th Circuit held that an Arizona statute removing an IRA beneficiary upon divorce passed constitutional muster and awarded the funds to the IRA owner’s estate. In this case, the IRA was established in 1992 and the Arizona law was passed in 1995, which led to a challenge similar to the one in Sveen that the contracts clause had been violated. As in Sveen, the state statute prevailed.

On June 18 this year, after issuing their ruling in the Sveen case, the U.S. Supreme Court refused to hear the appeal in the Lazar case. By letting the lower court’s decision stand, the Supreme Court made it clear that state revocation upon divorce laws work and can apply to IRAs.

ERISA and federal preemption: While the Sveen case is a victory for state statutes like the Minnesota one, things are very different when federal law comes into play. In the case of Egelhoff v. Egelhoff, 532 U.S. 141, decided on Mar. 21, 2001, the Supreme Court made it clear that when it comes to employer plans, ERISA is the law of the land. In Kennedy v. Dupont, 129 S.Ct. 865 (2009), an ex-spouse remained named on an employer plan beneficiary form after a divorce. The Supreme Court said that meant she (the ex-wife) got the plan money. According to the court, the bottom line is that ERISA requires that a plan pay the funds to the beneficiary named on the beneficiary designation form.

Federal law preemption beyond ERISA can be seen in another case involving life insurance. In Hillman v. Maretta, U.S. Supreme Court, 133 S. Ct. 1943 (2013), the court ruled that a decedent’s ex-spouse, who was still named as his beneficiary, was entitled to receive his federal life insurance benefits, despite the fact that a Virginia state law said that an ex-spouse is removed as the beneficiary after divorce.

The court said that in this case, the state law interfered with federal law and that federal law prevailed. Notably, the court did not say that state statutes can’t be applied to other assets with death benefits when there are no competing federal laws. In Sveen, the Supreme Court did exactly that with a life insurance policy.

Advisors can easily avoid these horror stories by being vigilant about checking beneficiary forms for all IRAs, 401(k)s, life insurance policies and all other assets with beneficiary designations.

No one really wins a long court battle when needed assets are at stake.