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George F. Bearup, J.D. Senior Legal Trust Advisor

9-Nov-20

Deemed IRA Distributions

Take-Away: A deemed distribution from a retirement account can create a serious tax trap since the distribution will be subject to immediate income taxation, and possibly the 10% penalty for early distributions if the IRA owner or plan participant is under the age 59 ½. The primary traps are when a retirement account is pledged as security or when the IRA owner engages in a prohibited transaction.

Background: The Tax Code provides that distributions from non-exempt, i.e. nonqualified, employee benefit plans are taxed on amounts ‘actually distributed or made available’ under the plan. [IRC 402(b)(2).] The Tax Code also describes events that can cause the participant, or IRA owner, to be currently taxable on the retirement benefits without an actual distribution, i.e. a deemed distribution. If the deemed distribution occurs while the account owner is under age 59 ½, then the 10% early distribution penalty will also apply. [IRC 72(t).] This results in the account owner paying income tax ( and possibly penalties) on the account value just as if the entire account had been distributed to him or her.

Assignment or Pledge of Retirement Account: An assignment, pledge, or other transfer of an IRA to another person causes a deemed distribution of the account. [IRC 72(e)(4)(A)(ii).] This can happen innocently enough, such as when the title to an IRA is mistakenly changed (an assignment) to the IRA owner’s revocable trust in the belief that the IRA will avoid probate. In addition, sometimes a pledge can arise when the IRA owner maintains a separate brokerage account and engages in margin borrowing, where all accounts of the borrower (including his or her IRA) held by the broker are pledged as security to repay the margin loan. A deemed distribution from a retirement account can even arise through no fault of, or intentional act, of the retirement plan account owner.

  • Example: A court ordered the pledge of the owner’s IRC 403(b) retirement annuity as security for the court’s imposed spousal support obligation. That court ordered pledge was held to be a taxable deemed distribution of the 403(b) account to the account owner. Coppola v Beeson, 419 F. 3d 323 (Fifth Circuit Court of Appeals, 2005.)
  • Example:  A divorcing husband argued that he should not be taxed on a pension distribution that he used, pursuant to a court order, to purchase his wife’s share of their home. The husband claimed that the distribution was nontaxable under IRC 1041 as a divorce-related asset transfer. The husband lost that argument and was treated as taking a deemed distribution from his retirement account. Toombs, Tax Court Summary Disposition, 2013-51.
  • Example: A decade ago the Department of Labor provided an Advisory Opinion that a stock brokerage firm’s standard ‘cross-collateralization agreement, where assets held in any account, including an IRA, were security for debts in the customer’s other non-IRA accounts created a prohibited transaction, i.e. an extension of credit relying upon the IRA. [DOL Advisory Opinion, 2009-03A and 2011-09A.] The IRS later provided a contrary position, creating a temporary exemption for this situation, in which it held that there would be no prohibited transaction unless the cross-collateralization was actually activated, meaning the IRA assets were actually taken to satisfy the IRA owner’s loan. [IRA Announcement 2011-81.]
  • Qualified Plan Loan Exception: The only exception to this rule  prohibiting pledges is if the pledge of IRA assets is given to secure that former employee’s obligation to repay a qualified plan distribution in very narrow circumstances. [Private Letter Ruling 2006-0605.]

Nor is the transfer (assignment) of a decedent’s IRA to its beneficiary a taxable event. [IRC 408(d)(3).]

Self-Directed IRAs and Prohibited Transactions:  A prohibited transaction includes any direct business transaction with an IRA, such as a sale, lease of property, or payment for goods and services between the IRA and a disqualified person, i.e. the IRA owner and his/her immediate family members. The transaction is prohibited even if the IRA is not financially harmed. [IRC 4975(c)(1)(A)-(D).] While any traditional IRA can be the subject of a prohibited transaction, the risk is even greater with a self-directed IRA. Self-directed IRA owners are notoriously aggressive in how they handle their IRA and the investments held in their IRA.

  • Penalty for Prohibited Transaction: The punishment for an IRA owner who engages in a prohibited transaction that involves his/her IRA is that the IRA is disqualified, and the account ceases to be an IRA and is deemed to have been entirely distributed on January 1 of the year in which the prohibited transaction occurs. [IRC 408(e)(2); IRC 408A(a).]
  • Example: The IRA owner sells property to his IRA at a bargain price; that sale would be a prohibited transaction even though his or her IRA  gets a good deal with the purchase.
  • Example: The IRA owner’s spouse earns a real estate commission outside the IRA for a transaction that involves the IRA’s real estate.
  • Example: The IRA acquires a collectible, e.g. an oriental rug. That acquisition will be deemed to be a distribution of the cost of the collectible to the IRA owner. [IRC 408(m)(1) and (2).]

Qualified Plan Loan Default: If a participant defaults on a loan taken from his or her qualified plan account, that default will be treated as a deemed distribution of the entire account balance. [Treasury Regulation 1.72(p)-1.]

Roth Rollover: The direct rollover of assets from a qualified retirement plan account or a traditional IRA to a Roth IRA is taxed as a deemed distribution to the account owner. [IRC 408(d)(3)(A).]

Roth Gift: Normally funds that are held in a Roth IRA are treated as distributions only when they are actually distributed from the Roth IRA. But the assignment of the Roth IRA by a lifetime gift ‘to another individual’ will cause the Roth IRA to be deemed distributed to the owner-donor; consequently, after the assignment, the IRA will cease to be a Roth IRA. [Treasury Regulation 1.408A-6, A-19.]

Plan Owned Life Insurance: The ownership of a life insurance policy on the life of the participant in his or her qualified retirement account [an IRAs cannot hold life insurance] will cause part of the cost of insurance premium to be currently taxable income to the participant when premiums are paid from plan earnings or contributions. [IRC 72(m)(3) and IRC 402(a).]

Conclusion:  There are many different ways in which to encounter a deemed distribution from a retirement account under the Tax Code. A familiarity with these rules is important when advising the owner of a retirement account since many of these situations will cause the entire IRA account, not just the deemed distribution amount in question, to lose its tax exempt status.