IRAs: Mistakes and Misconceptions

Take-Away: A week ago I provided a review of the stretch IRA rules. I mentioned that often there are a lot of mistakes either in applying required minimum distribution (RMD) rules or making assumptions that are not always accurate. What follows are some mistakes and misconceptions often encountered in the world of IRAs.

Failure to take the Owner’s Last RMD: If the IRA owner is over the age of 70 ½ and dies before taking his/her RMD for that calendar year, a mistake is often made that the designated beneficiaries of the owner’s IRA are not required to take it, assuming instead that the RMD is owed to the deceased owner’s estate. That is the wrong assumption to make. When the owner’s year-of-death RMD is not taken in full, the IRA’s designated beneficiaries are required to take that RMD (or the balance of the RMD not previously taken by the owner) and include it in the beneficiaries’ individual incomes for that tax year. If there is more than one designated beneficiary, all the beneficiaries report, ratably, the decedent’s taxable last-RMD distribution on their own Form 1040 tax returns for that calendar year.
Failure to take an RMD. A missed RMD by the beneficiary of an inherited IRA triggers a 50% penalty of the amount that was supposed to have been taken as a distribution. This is a ticking time-bomb becomes if the IRA is trapped in some type of probate court litigation with regard to the decedent’s estate and a probate court order prohibits any type of distribution from either the decedent’s estate and all non-probate transfers, like an IRA distribution, pending the outcome of that litigation.
Failure to take a Roth RMD: The inherited IRA rules often get confused with other IRA rules, such as a Roth IRA which normally does not require its owner to take RMDs from the Roth IRA. Even when a Roth IRA is inherited, it is still subject to the RMD rules for its beneficiary. It is only the Roth IRA owner, or the Roth IRA owner’s surviving spouse, who does not have to take an RMD from the Roth IRA. Failure to timely take the Roth IRA RMD leads to the 50% penalty.
Improper IRA Rollovers: Only a surviving spouse can make a 60 day rollover of a deceased spouse’s inherited IRA. If the non-spouse IRA beneficiary makes an improper rollover of the inherited IRA to their own IRA, that transfer is taxed as a distribution to the beneficiary. There are no 60 day rollover opportunities when moving funds from an inherited IRA to another inherited IRA. [IRC 408(d)(3)(C)] The transfer of the inherited IRA can only be made from the deceased owner’s IRA custodian to another IRA custodian selected by the beneficiary.
Improper IRA Contributions: If the IRA beneficiary mistakenly treats the inherited IRA as his/her own IRA, and makes a contribution of that inherited IRA to his/her own traditional IRA, i.e. he/she consolidates them into a single IRA, that contribution will disqualify the traditional IRA and make its entire balance immediately taxable (and possibly subject to the early withdrawal penalty as well.)
Improper Mixing of Inherited IRAs: Using the example from last week, assume that parents Ward and June both had IRAs. Ward and June die in a common disaster auto accident. Both Ward and June named their son Wally as the sole beneficiary of their IRAs. Wally cannot combine these two inherited IRAs into a single inherited IRA account. Inherited IRAs cannot be mixed with assets in any other kind of retirement account, except an IRA of the same kind, traditional or Roth, and inherited from the same individual. Accordingly, if June had two different traditional IRAs with two different IRA custodians, and Wally was named as the sole beneficiary of each of these two traditional IRAs owned by June, Wally could combine the two traditional inherited IRAs into a single inherited IRA account (same type, from the same person.) If June had one traditional and one Roth IRA account, and Wally was named beneficiary of both IRAs, Wally could not combine them into a single inherited IRA (while the source is the same, one is a traditional IRA and the other is a Roth IRA.)
Failure to Distinguish a rollover IRA and a contributory IRA: This distinction leads to different results in the realm of creditor protection. The federal bankruptcy laws treat IRAs and qualified retirement accounts differently. [11 USC 522(n)] Currently the Bankruptcy Code protects in bankruptcy up to $1.0 million (increased by an inflation adjustment annually) of a traditional, or contributory, IRA. In contrast, the federal Bankruptcy Code protects an unlimited amount held in a qualified plan account, e.g. a 401(k) account balance. Importantly, if a plan participant retires and rolls his/her account balance into a rollover IRA, the bankruptcy laws will trace those former qualified plan assets into the rollover IRA and that unlimited amount that is exempt in bankruptcy will continue to be protected in a future bankruptcy proceeding. But if the qualified plan assets are added to a traditional, or contributory, IRA it is difficult to prove what portion of the IRA is protected, and not protected, in a future bankruptcy proceeding, when earnings start to accumulate in the IRA. The taxpayer-bankrupt has the burden of proof to trace the claimed exempt qualified plan funds now held in a traditional IRA. It is much better if a plan participant is retiring and rolling out their retirement funds from the qualified plan, to place those funds into a new IRA that the participant creates-a new IRA that is intended just to receive the funds to be transferred from the qualified plan. This thus avoids commingling the traditional contributory IRA assets with the rolled over qualified plan assets into one IRA account, and making it easier to protect them in bankruptcy.
Assuming All State Creditor Exemption Laws Are the Same: This distinction between a qualified plan account assets and a traditional IRA assets can also apply to exempt assets under state creditor exemption statutes. Some states limit the amount of IRA assets that are exempt from creditor claims, or limit the exemption amount ‘only to the extent necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and the dependents of the judgment debtor taking into account all other resources of the debtor.’ If funds are not rolled into an IRA from a qualified plan account they are much more apt to be preserved and not be exposed to dollar limits under state exemption statutes that may only marginally protect an IRA from satisfying the IRA owner’s creditor’s claims. If the qualified plan funds are rolled out from the qualified plan into a rollover IRA, some state creditor protection laws will exempt those former qualified plan assets, even though they are now held in an IRA. In short, if creditors are lurking, the participant would be wise to NOT roll any amounts out of their qualified plan account into an IRA, but if they do so, it is much better to place those rolled out funds in a segregated IRA.
Assuming Inherited IRAs are Creditor Protected: While states and the federal Bankruptcy Code provide some protection for IRAs, that protection is only for contributory IRAs and not inherited Only a couple of states extend creditor protection to inherited IRAs, e.g. Arizona, but not Michigan. Thus the assumption that all IRA accounts are protected from creditor claims is erroneous. Only contributory IRAs are protected. In Clark v. Rameker, 113 AFTR2d 2014-2308, the US Supreme Court made it clear that an inherited IRA is not a retirement account and thus it does not fall within the protections of the US Bankruptcy Code’s 552(b)(3)(C). In light of this decision, for those IRA owners who are worried about their intended beneficiary losing the inherited IRA to their creditors, it would be better to direct the IRA on the owner’s death to a Trust to receive RMDs into the trust and not pay the IRA directly to the individual beneficiary. The trust’s spendthrift clause can then protect the distributions the trustee receives from the inherited IRA.
Treating an IRA as Community Property: As a general rule, state property laws will identify and govern property interests, while federal tax law will govern the taxation of those state identified and controlled property interests. That is usually the case, but not when it comes to IRAs. The Tax Code makes it clear that the IRA distributions will be ‘applied without regard to community property principles.’ [IRC 408(g).] This may not be a big issue in Michigan, which is not a community property jurisdiction, but many married clients may accumulate their IRAs in community property jurisdictions and later move to Michigan, bringing their IRA with them. This was the issue in last year’s private letter ruling issued by the IRS that lead to a horrific result. [PLR 201623001.] In that case the husband died in California (a community property jurisdiction) with an IRA. He named his son as the sole beneficiary of the IRA, not his wife. Since the IRA was accumulated during the marriage in a community property jurisdiction, the surviving spouse had a legal claim to 50% of the accumulated IRA balance. The widow filed a petition in the California probate court claiming her one-half of her late husband’s IRA. The probate court agreed with her petition based upon normal community property principals, and the court ordered the son to transfer 50% of his late father’s IRA to a rollover IRA that his mother created to receive her 50% share of her late husband’s IRA. The son complied with the probate court’s order. The IRS held in its private letter ruling that: (i) IRC 408(g) permits the parties to ignore community property principles with regard to their IRAs, despite California law to the contrary treating the IRA as community property; (ii) by following the probate court’s order, the son received a taxable distribution of 50% of his inherited IRA, on which the son, not his mother, had to pay the income tax; and (iii) the widow could not treat the amount ordered paid by the California probate court to her IRA as a rollover IRA, since she was not entitled to any amount of her late husband’s IRA, having not been named as its beneficiary. As such, the widow was treated as having made an excess contribution to her IRA (contributing much more than was legally permitted) and thus if she did not ‘fix’ the problem by pulling the funds out of the claimed rollover IRA, she would have to pay a penalty or could risk having her entire IRA disqualified. By following the probate court order, the son lost not only 50% of his inherited IRA, he had to pay the income tax on the 50% that he did not receive, not to mention the income taxes on his retained 50% of the inherited IRA.
Failure to Distinguish a Contingent Beneficiary from a Successor Beneficiary: We all know that if an IRA is made payable to a trust, instead of an individual, that we need to structure the trust as a ‘see-through’ trust so that the trustee can exploit the stretch IRA With a ‘see-through’ trust the trustee then uses the oldest trust beneficiary’s life expectancy to calculate the required minimum distribution (RMD) paid into the trust. Thus, one of the four conditions for the trust to qualify as a ‘see-through’ trust is the need to be able to identify all of its beneficiaries. But this is where the rules can get really complicated. Some beneficiaries can be ignored in the search for the oldest trust beneficiary. The Regulations state that a contingent beneficiary has to be considered in determining which trust beneficiary has the shortest life expectancy. In contrast, a successor beneficiary will not have to be considered for this purpose of determining the oldest trust beneficiary. A successor beneficiary is a person who merely could become the successor to the interest of one of the IRA owner’s (or trust’s) beneficiaries after the beneficiary’s death. [Reg.1.401(a)(9), Q&A-7(b).]But it is not that simple of an analysis. The Regulations go on to state that a beneficiary will not be excluded from this ‘oldest trust beneficiary’ determination if that person has any right (including a contingent right) to an IRA owner’s benefits beyond being a mere potential successor to the interest of one of the IRA owner’s beneficiaries upon that beneficiary’s death. (Head spinning yet?) Example: If the first beneficiary has a right to all trust income with respect to the IRA owner’s account during that beneficiary’s life and a second beneficiary has a right to the principal, but only after the death of the first income beneficiary, both beneficiaries must be taken into account to determine the beneficiary with the shortest life expectancy. So if I create a trust and require the trustee to pay all income from my IRA payable to the trust to my 33 year old son, and principal to my 98 year old mother, my mother’s life expectancy will govern the trustee’s required minimum distributions from my IRA that is made payable to that trust. If my mother were not eligible to receive any distributions from the trust until my son’s death if he did not survive to a certain age, my aged mother would then only be treated as a mere successor beneficiary and her life expectancy would be ignored for purposes of calculating RMDs.
Adding Powers of Appointment to Accumulation Trusts: In these days of drafting trusts for flexibility, one popular tool is to give to a lifetime trust beneficiary a power of appointment over the trust assets, in effect permitting the trust beneficiary to re-write parts of the trust to respond to the changing needs of the beneficiaries though the exercise of that power of appointment. But adding a power of appointment to a trust may inadvertently add an older contingent beneficiary to the trust, thus shortening, or eliminating, the RMD period that controls the trustee’s withdrawals from the IRA. If that power of appointment could be exercised in favor of an older person than the beneficiary, or worse yet, in favor or a charity (a non-individual beneficiary) then the opportunity to take RMDs over an extended period may be lost. In short, a broadly phrased power of appointment can result in the trustee having to consider a much broader swath of beneficiaries for IRA distribution purposes than might have been intended, especially if one of those potential appointees if the power of appointment is exercised does not qualify as a ‘designated beneficiary.’ [PLR 201021038.] If the trust instrument gives a beneficiary a power of appointment, you may have a problem since the potential appointees will be treated as contingent beneficiaries of the trust.
Confusing the Separate Share Rule with the Direction to Divide by the Trustee: You have heard about this from me frequently in the past. The separate shares for the trust beneficiaries, in order for them to use their own life expectancy for their own required minimum distributions from their own portion of the IRA payable to the trust, must occur in the IRA beneficiary designation that names the trust, not in the trust instrument itself. While the trust instrument may direct the trustee to divide all assets coming into to the trust into separate shares of equal value, that division, in the trust instrument, will still cause the trustee to take RMDs for all trust beneficiaries using the oldest individual trust beneficiary’s life expectancy. Each sub-trust created for each trust beneficiary must be designated as the beneficiary in the IRA beneficiary designation form for the oldest beneficiary of that sub-trust to use his/her own life expectancy for required minimum distributions. So, rather than assume that the direction to the trustee to create equal shares in the trust instrument will be sufficient to permit both A and B to use their own life expectancies for RMD calculations, the sub-trusts created for each of A and B must be named in the IRA beneficiary designation in order to obtain that result. [Reg. 1.401(a)(9)-8, Q&A-2(a)(2).] This is a common mistake many make, assuming that the trust instrument that contains the division direction is sufficient- it’s not. The division into equal shares must occur in the beneficiary designation, not the trust instrument.
Assuming a Probate Court Can Provide a ‘Fix’: Innocent mistakes will happen, they all too often do occur. But running off to probate court for an order that ‘fixes’ the problem usually will not work when it comes to IRAs. A reformation of a trust instrument to extend the RMDs taken by the trustee is usually not effective. The IRS will ignore and disregard a state court order that attempts to retroactively name and designate a beneficiary (or remove all undesirable beneficiaries) as of the date of the IRA owner’s death. [ See the Estate of La Meres, 98 TC 2994 (1992); PLR 201021038, where a valid trust reformation under state law was still ignored by the IRS.]
Applying the ‘See Through’ Rule to a Will: While the Tax Code and Regulations contemplate ‘seeing-through’ a trust to use the life expectancy of the oldest trust beneficiary for RMDs, that same approach will not apply to a Will. For example, Ward names June as beneficiary of his IRA. They have one child, Wally. June dies. Ward then dies, but he did not name Wally as the contingent beneficiary of his IRA. Ward leaves a will that names June as the primary beneficiary of his estate, with Wally named as the contingent residuary beneficiary of Ward’s estate. Thus IRA will be paid to Ward’s estate, and Wally will inherit, through Ward’s will the IRA assets, as the sole contingent beneficiary of Ward’s estate. As a general rule, the passing of an IRA under the IRA owner’s will, or pursuant to applicable state law, e.g. intestacy, will NOT make that individual a designated beneficiary for purposes of a stretch IRA; the only exception is if that individual, as contingent beneficiary, is named as a beneficiary under the qualified plan documents or a IRA custodial agreement.[Reg. 1.401(a)(9)-4 A&A 3.] The IRS may be more accommodating if the ‘indirect’ beneficiary of the IRA passing under the deceased owner’s will is a surviving spouse and also personal representative of the deceased spouse’s estate. But for non-spouses, the IRS is not nearly as accommodating.

Undoubtedly this is much more than you ever wanted to know about IRAs and RMDs. But when you consider how much wealth is held in IRAs of Baby-Boomers, controlled by the beneficiary designations and not the Baby Boomer’s will or trust, you have to have a working knowledge of the IRA distribution rules and some of the special rules in the law to protect IRAs from creditor claims. I wish I could make them easier to understand or remember, but sad to say that is not going to happen.