Deferred Compensation & Divorce: IRAs, Military Pensions, Disability Insurance Benefits, and Marital Nexus | PART TWO
In Tennessee law, deferred compensation includes a spouse’s income deferred by the employer for already-performed work, functioning as a “substitute for life savings.” See Gragg v. Gragg, discussed later.
When earned during the marriage, a deferred compensation plan may be a divisible marital asset along with any appreciation, or increase in value, that also happened during the marriage. Contrast that outcome with a spouse’s IRA account established and funded before the marriage. With the IRA, any increase in value accruing during the marriage remains the owner’s separate property unless the other spouse substantially contributed to the preservation and appreciation of the asset. We touched on this in Part One.
In Tennessee divorce law, deferred compensation includes a spouse’s income deferred by the employer for already-performed work, functioning as a “substitute for life savings.”
In addition to the marital home, retirement assets frequently make up the lion’s share of the spouses’ marital estate. With divorce, spouses are almost always better off stipulating or agreeing to the classification, valuation, and division of their marital assets and debts by including terms in a Marital Dissolution Agreement, or MDA. If that isn’t possible or if the spouses just don’t know how to proceed, then those determinations must be made by the judge.
Predictably, the trial court’s findings and classification of retirement accounts and deferred compensation as separate property or marital property, and resulting equitable distribution, often forms the basis for challenge on appeal. These cases tend to hinge on two factual findings by the court:
- Classification of an IRA, 401(k), or fringe benefit as a separate or marital asset; and
- Classification of increased value or appreciation during the marriage as a separate or marital asset.
As a point of departure, if the spouse’s plan is classified as 100 percent marital deferred compensation, then one would expect any appreciation on that plan to be marital property, too. With a premarital IRA that was never marital property, one would expect any appreciation on that IRA occurring during the marriage to also be classified as separate property (excepting transmuted, commingled, or property gifted to the marriage or other spouse).
When looking at deferred compensation owned by a spouse before the marriage, whether the plan is qualifying or non-qualifying, any appreciation or increased value accrued during the marriage may or may not be separate property, depending upon the facts and circumstances. The controlling property division statute is T.C.A. § 36-4-121(b)(1)(B) and its “first clause” and “second clause.” That’s where things get confusing.
We have summarized several noteworthy cases to illustrate what factual nuances to look for. To identify a marital component of deferred compensation, which is subject to division and distribution in divorce, requires applying the proper analysis under the statute. Courts have struggled some in their attempts to do this.
Cases Classifying Deferred Compensation in Tennessee Divorce
Since 2000, several appellate court opinions have carefully analyzed how deferred compensation should be classified in Tennessee divorce. As you read these case summaries, focus on factors distinguishing marital deferred benefits from separate ones, along with any appreciation of the plan. The first case involved military retired pay as marital property.
Military Retired Pay Was Marital Deferred Compensation,
Johnson v. Johnson
In this military divorce, the spouses’ MDA provided that the wife would receive one-half of her husband’s military “retirement benefits” as marital property when he retired. Johnson v. Johnson, 37 S.W.3d 892 (Tenn. 2001). For almost a year, she received her share of the husband’s military retired pay without issue.
When did the wife’s interest vest in the husband’s military retired pay?
After the divorce, Mr. Johnson, who had served in the U.S. Marine Corps, elected to waive a portion of his retired pay in exchange for non-taxable military disability benefits. This was his right under federal law. When his disability benefit kicked in, his military retired pay was necessarily reduced by the disability payment amount. As a consequence, the wife’s monthly payments from the military pension were also cut by $181.00. She sought a remedy, but the trial court denied her motion to modify the divorce decree. A ruling the Court of Appeals affirmed.
When Did Wife’s Interest Vest in Husband’s Military Retired Pay?
Placing substance over form, the Tennessee Supreme Court interpreted the wife’s motion as a petition to enforce the decree’s marital property distribution (the MDA). The Supreme Court held that husband’s “retirement benefits” vested with the wife when the divorce decree was entered. Furthermore, Mr. Johnson could not unilaterally alter the MDA agreement thereafter without violating the judicial order:
“Any act of the military spouse that unilaterally decreases the non-military spouse’s vested interest is an impermissible modification of a division of marital property and a violation of the final decree of divorce incorporating the MDA …”
The wife’s interest in her husband’s military pension vested the day of the divorce. Her vested interest could not be diminished unilaterally thereafter. He could not in any way “frustrate receipt of her vested interest.” (Reducing her vested interest in husband’s military retired pay would require her voluntary consent and agreement, which she did not give.)
Reversing the appeals court, the case was remanded for enforcement by the trial court. The spouses in Johnson agreed to classify and divide husband’s military pension. But when spouses are not in agreement, is one spouse’s disability benefits marital property?
Disability Insurance Benefits Were Not Deferred Compensation,
Gragg v. Gragg
In a Shelby County divorce, a medical doctor specializing in anesthesiology obtained two disability insurance policies from private insurers to provide him with income should he become disabled. Gragg v. Gragg, 12 S.W.3d 412 (Tenn. 2000).
The Graggs were married in 1971, separated in 1993, and Dr. Gragg filed for divorce in September 1994. The following month, he became totally disabled. The spouses agreed all marital property should be divided equally between them.
Husband’s Disability Insurance Policies
Dr. Gragg’s first policy (purchased in 1977) promised $2,000.00 per month upon disability until age 65 when most retire, with waiver of premiums during disability. The second policy (purchased in 1988) promised $5,000.00 per month, automatic 5 percent annual cost of living increases, benefits paid throughout his lifetime so long as he remained disabled, with waiver of premiums during disability. Both were casualty policies. Both were established during the marriage. Both were paid for with his earnings – an aggregate cost of $45,000.00 in marital funds.
Are disability benefits marital property as deferred compensation? The trial court answered in the affirmative, finding the disability benefits paid “both before and after the divorce constitute[d] marital property … pursuant to T.C.A. § 36-4-121(b)(1)(B).” The husband filed a timely appeal.
The Court of Appeals reversed the trial court’s finding that disability income benefits were marital assets. Instead of being classified as marital property, the disability benefits “constituted substituted income to Husband and are available for such obligations as might be imposed by the court” – that is, alimony and child support. The wife was granted review by the Tennessee Supreme Court.
Are disability benefits paid to one spouse on a private insurance policy acquired during the marriage, the policy having been paid for with marital funds, marital property? No, not under these circumstances. The husband’s disability benefits were a replacement for lost income following his disability. They were not deferred compensation for services rendered within the meaning of the second clause of the marital property statute.
Statutory Language Simply Illustrative
In the Supreme Court’s statutory construction, property interests identified in § 36-4-121(b)(1)(B) “are simply illustrative of the types of intangible property interests that may be classified as marital property.” Other intangible assets similar to those enumerated should also be considered marital property.
Take another look at the statute:
(B)(i) “Marital property” includes income from, and any increase in the value during the marriage of, property determined to be separate property … if each party substantially contributed to its preservation and appreciation;
(ii) “Marital property” includes the value of vested and unvested pension benefits, vested and unvested stock option rights, retirement, and other fringe benefit rights accrued as a result of employment during the marriage;
Contrasting his private disability insurance policies from the deferred compensation enumerated in the second clause, Dr. Gragg successfully argued that his disability insurance benefits cannot be deferred compensation for services rendered because they replaced future income. Because future income is not marital property, disability insurance benefits are not marital property. Because disability benefits are not marital property, they may only be used to determine alimony or child support obligations.
Rejecting the minority jurisdictions’ “mechanistic approach,” the Supreme Court adopted the “analytical approach” of the majority jurisdictions wherein “benefits which actually compensate for disability are not classified as marital property because such benefits are personal to the spouse who receives them and compensate for loss of good health and replace lost earning capacity.”
However, under the analytical approach an important exception exists whenever the disability benefit has a “true disability component” (separate property) that is separable from a “retirement component” (marital property). Should facts support such a dual finding, the retirement benefit portion of the disability payment may be marital deferred compensation and divisible in divorce.
Because pensions and retirement benefits compensate individuals who live past retirement age, noted the court, they are deferred compensation for services rendered (functioning as a “substitute for life savings”). Retirement benefits and pensions, like joint savings accounts funded during marriage, are marital property. By contast, disability benefits are not a substitute for savings. Instead, they protect against an inability to earn income as the insured had in the immediate past. “[D]isability benefits replace income which is lost before retirement.” Disability benefits replace the insured’s future lost earnings and should be treated as income. Since future income of a former spouse is not marital property, neither are income-replacing disability benefits even though the policy premiums were paid with marital funds.
In Gragg, because future income is not marital property, disability insurance benefits are not marital property.
That disability benefits were a replacement for lost income was dispositive. That marital funds paid the private disability insurance policy premiums was not dispositive.
The next case involved the husband’s premarital investment funds, one of which was an individual retirement arrangement, or IRA.
Substantial Contribution Nexus to Preservation and Appreciation of Separate IRA,
Langschmidt v. Langschmidt
In Langschmidt, the Tennessee Supreme Court held that neither husband’s premarital IRA nor his non-IRA investments were marital property subject to equitable division. Langschmidt v. Langschmidt, 81 S.W.3d 741 (Tenn. 2002). Here’s why:
- First, both funds were classified as separate assets;
- Second, the wife did not substantially contribute to the preservation and appreciation of either asset, so the increased value that accrued during the five-year marriage remained husband’s separate property; and
- Third, premarital IRAs are not marital deferred compensation or retirement benefits within the second clause of T.C.A. § 36-4-121(b)(1)(B).
Once again, the Supreme Court interpreted the statute before applying the law to the facts of the case before it. Take a look at this important case.
A second marriage for both, the couple wed in 1992 when Mr. Langschmidt was a 61-year-old lawyer and widower. His bride was a 44-year-old school teacher and divorcée with two teenage sons. As the economically advantaged spouse, the husband encouraged his wife to stop working full time and rely on his substantial financial resources. She became homemaker until April 1997 when she filed for divorce.
In equitably distributing the marital estate, the trial court awarded the wife a portion of the appreciation on her husband’s two premarital investments. Although neither investment received marital funds, both increased in value during the marriage. The trial court found that wife’s role as homemaker substantially contributed to the preservation and appreciation of her husband’s investments. Therefore, appreciation on those accounts were marital assets under the first clause T.C.A. § 36-4-121(b)(1)(B). Two appeals followed.
The state Supreme Court affirmed the appeals court in part, reversed it in part, and remanded to the trial court for further proceedings. Here’s how the Supreme Court characterized husband’s two premarital investments.
Premarital Non-IRA Investments
Were non-IRA investments marital or separate property? Mr. Langschmidt’s premarital non-IRA investments (money market account, CD, bonds, separate bank accounts, and stocks) appreciated $171,628.00 during the marriage, but were not contributed to during the marriage. The Supreme Court held husband’s non-IRA investments were his separate property, affirming the Court of Appeals. Next question.
Was appreciation on the non-IRA investments marital or separate property? Not under these facts and circumstances. Despite how “’substantial contribution’ may include … the direct or indirect contribution of a spouse as a homemaker” under T.C.A. § 36-4-121(b)(C), Mrs. Langschmidt did not substantially contribute to the preservation and appreciation of the non-IRA assets as required by the first clause of T.C.A. § 36-4-121(b)(1)(B).
Key to the Supreme Court’s analysis was the trial court’s finding that the increased value of the non-IRA investments was “completely market-driven” – passive. Because no other forces were determined at trial to have contributed to the investment’s appreciation, the wife’s role as homemaker must have had little or no impact.
Nexus of Marital Effort and Separate Property’s Appreciation
When is the other spouse’s effort sufficient to establish a substantial contribution to preservation and appreciation? A “link between the marital efforts of a spouse and the appreciation of the separate property must be established before the separate property’s appreciation is considered marital property.” There must be a nexus between appreciation in value during the marriage and targeted action taken by both spouses. The nexus must be supported by evidence at trial. For example, equity in a spouse’s separate real estate can become a marital asset when funds from the spouses’ joint checking account were used to pay the mortgage (establishing a causal link between increased equity and marital efforts).
Premarital IRAs Are Not Marital Deferred Compensation
Mr. Langschmidt’s premarital IRAs and appreciation were next. Were his IRAs marital or separate property? Held to be husband’s separate assets, the court reaffirmed the rule: “[W]hen an IRA is funded entirely with separate premarital earnings, the IRA is separate property.” The court concluded that, because these were entirely funded with premarital assets, the IRAs were not deferred compensation (or retirement benefits) earned during the marriage within the second clause of T.C.A. § 36-4-121(b)(1)(B). But the analysis didn’t stop there.
Was appreciation of the IRAs marital or separate property? The amount of appreciation on a separate asset is subject to equitable distribution when the other spouse substantially contributed to its preservation and appreciation. The trial record did not indicate that wife substantially contributed to the preservation and appreciation of her husband’s IRAs. The Supreme Court held that appreciation accrued on the IRAs during the marriage was also separate property. (The exception was Mr. Langschmidt’s 401(k). Contributed to during the marriage and rolled into an IRA, the case was remanded for its valuation.)
Classification of Deferred Compensation Pivots on Trial Court’s Factual Findings
The trial court’s findings are pivotal in classifying any deferred compensation, retirement plan, or fringe benefit as marital or separate property. If appreciation of a premarital asset was exclusively the result of market forces, then the owner and his or her divorce attorney should substantiate that with evidence at trial. If the other spouse substantially contributed to the retirement asset’s preservation and appreciation, then he or she must provide evidence – more than being the homemaker – of a nexus between increased value and marital effort.
Continue reading Part Three.
