Take-Away: A non-spouse beneficiary cannot use a 60-day rollover with regard to an inherited traditional IRA. Only a custodian-to-custodian transfer of the inherited IRA will work to avoid immediate income taxation of the inherited IRA.

Background: One critically important distribution rule is that a non-spouse beneficiary cannot perform a 60-day rollover of an inherited IRA. If the IRA funds are transferred to a non-spouse beneficiary, the distribution is fully taxable, even if that non-spouse beneficiary transfers the funds into a new IRA within 60 days of receipt, which is the conventional rollover distribution rule.

One Example of Custodian-to-Custodian Rule: An adult daughter inherited her mother’s traditional IRA. The account balance was $38,186. Soon after the mother’s death the IRA custodian issued to the daughter two checks- one for $2,282 and one for $35,358. Either the daughter requested these distributions or she otherwise tacitly consented to the distributions. Perhaps the smaller check was the deceased mother’s RMD for the calendar year that the mother had not taken before her death. The daughter retained the smaller of the two checks, and she transferred (rolled) the larger check into an IRA account that she had with another IRA custodian, all within 60 days of her receipt of the larger check. The daughter, thinking she had effected a timely 60-day rollover, did not report the larger check amount in her taxable income for the year of its receipt. The IRS issued to the daughter a notice of deficiency for $9,000. The daughter’s dispute with the IRS ultimately moved to the U.S. Tax Court. The daughter argued that she had misunderstood the IRA distribution rules, that she had otherwise complied with the 60-day rollover rule, and that she had always intended to roll over the larger check from her deceased mother’s inherited IRA. In short, the daughter argued that she had ‘substantially complied with all of the relevant IRA distribution rules’ and accordingly she thought the IRS should cut her some slack. The Tax Court found that the daughter’s actions, or her intention with regard to the distribution, were irrelevant to the tax laws. The Tax Court noted:

  • The only way a non-spouse beneficiary can transfer an inherited IRA is through a direct custodian-to-custodian transfer. Because the daughter did not do this, she was left with a taxable distribution of the larger check.
  • There was no way that the IRS, or the Tax Court, could fix the daughter’s mistake the way the tax laws and IRA distribution rules are currently written.
  • The income tax liability was $9,000. The Tax Court decision is silent if penalties or interest were assessed, as the deposit was made into the daughter’s IRA in 2008 and the decision of the Tax Court was issued in 2012.
  • The daughter’s situation arguably could have been worse. Since the $35,358 was ineligible for an IRA contribution by the daughter, it was technically an excess contribution to the daughter’s IRA. Accordingly, that excess contribution needed to be removed from the daughter’s IRA by October 15 of the calendar year that follows the contribution by the daughter. If that excess contribution was not removed by that date, the IRS would impose a 6% penalty for each calendar year that those excess contribution assets remained in the daughter’s IRA account. As such it is possible that the daughter faced a 6% penalty for each year the excess contribution remained in her IRA (2008 through 2012.)
  • Citation: Beech et. ux. vs Commissioner, Tax Court U.S., Op. 2012-74, No. 1948-11-S (July 26, 2012).

Conclusion: An entirely different set of rules pertain to the transfer of funds from an inherited IRA to the beneficiary’s separate IRA. One example is that the name of the deceased IRA owner must remain on the account, e.g. ‘Mary Smith, deceased, IRA for the benefit of Susan Brown, beneficiary.’ Another important distinction is that no 60-day rollovers are permitted if the IRA beneficiary is a non-spouse beneficiary of the deceased IRA owner; only a custodian-to-custodian transfer of the inherited IRA is permitted to avoid immediate income taxation of the distributed amount. Finally, since required minimum distributions are required to be taken from an inherited IRA after it is inherited, it should not be commingled with the non-spouse beneficiary’s own IRA, where required minimum distributions are not required until the IRA owner attains age 70 ½.