IRAs: Mistakes Without Remedies

I recently read an article on IRAs which was a helpful reminder that some of the mistakes that are often made with IRAs cannot be ‘fixed.’ Since IRAs usually comprise a large part of our clients’ estates, we need to be vigilant as to how those IRAs are administered and how withdrawals are taken from the IRAs to avoid triggering those ‘mistakes without a remedy.’

1. Withdrawals from Inherited IRAs by Non-Spouses: If a non-spouse beneficiary of an inherited IRA takes an immediate distribution, a situation I saw time and again in my law practice when a young beneficiary eagerly took a lump sum distribution from their deceased parent’s IRA, that distribution is taxable. While the taxation of the IRA distribution is expected, what is not expected is that once the taxation of that immediate distribution becomes apparent, it cannot be fixed with a rollover by the beneficiary. In other words, if the beneficiary realizes the large income tax consequences associated with taking a lump sum distribution from their deceased parent’s IRA, there is NO 60 day ‘rollover’ into an ‘inherited IRA’ to avoid the income tax liability arising from the distribution. The 60 day ‘rollover’ rule only applies to a surviving spouse, not to non-spouse beneficiaries. If the non-spouse beneficiary wants to transfer the funds held in an inherited IRA, they cannot rely on a 60 day rollover rule; rather, the beneficiary must rely on a custodian-to-custodian transfer of the funds from one inherited IRA to a new inherited IRA. Failure to follow the custodian-to-custodian requirement results in the immediate income taxation of the entire inherited IRA, which cannot be fixed.
2. Failure to Comply with Technical Trust ‘See-Through’ Rules: Trusts are often used to receive IRA distributions on the death of the IRA owner to provide creditor protection, curb a spendthrift tendency of the beneficiary,  and to exploit the currently available ‘stretch IRA’ distributions rules that permit the tax deferred growth of the un-withdrawn funds in the IRA. For a Trust to qualify as a designated beneficiary entitled to exploit the ‘stretch IRA’ rules four conditions must be met, two of which are easy to meet, one is much more difficult, and one which should be easy to comply with, but for some reason is often overlooked. The two easy conditions are: (i) the trust must be valid under state law and (ii) the trust must become irrevocable on the death of the IRA owner/trust settlor. The more difficult condition to meet is that all of the trust beneficiaries must be identifiable, which can be challenging if there are charitable beneficiaries of the trust, or a word formula is used in the trust to identify potential trust beneficiaries. The last condition which should be easy to satisfy, but which is often overlooked, is that the trust document must be provided by the trustee to the IRA custodian [or a qualified plan administrator] no later than October 31 of the year following the death of the IRA or account owner. The Regulations refined this last requirement to permit furnishing to the IRA custodian a list of the trust beneficiaries and their entitlements under the trust, in lieu of providing a copy of the trust instrument to the IRA custodian,  which might otherwise defeat the confidentiality that the trust settlor sought when the trust was initially established. Here is the key: if the October 31 deadline is missed by the trustee, there is no extension, NO remedy, and the trust then ceases to be treated for tax reporting purposes as a designated beneficiary for ‘stretch IRA’ distribution rules. In short, he opportunity to exploit the ‘stretch IRA’ rule is forever lost. This overlooked administrative responsibility to timely deliver to the IRA custodian the copy of the trust instrument, or a list of trust beneficiaries and a summary of their entitlements,  often occurs when a family member serves as trustee of the intended ‘stretch IRA’ trust. This administrative responsibility rests with the trustee, no one else, and missing the October 31 deadline is a mistake that cannot be fixed.
3. One IRA Rollover Per Year- That’s It!: In 2014 the US Tax Court told us that we receive one IRA rollover every 12 months. [Bobrow] The once a year allotted 60 day rollover limitation applies to all IRAs, whether it is an IRA to IRA transfer, or a regular IRA to  Roth transfer, or a Roth IRA to Roth IRA transfer. Regular IRAs and Roth IRAs are treated the same for this once every 12 months rule. If an IRA owner violates this ‘one rollover every 12 months’ rule, then there is no relief available under current law to cure that mistake. If the IRA owner ‘blows’ this rule, and ineligible funds are held in an IRA, an excess IRA contribution exists, which is subject to a 6% excess accumulation penalty. That annual 6% penalty continues to be imposed until the excess deposited funds are removed from the IRA.
4. Losing the Opportunity to Pay Capital Gains  on Distributions: A little known rule is that if a qualified plan includes highly appreciated stock or bonds issued by the company plan sponsor, those assets can be subject to favorable taxation. A qualified plan participant can withdraw funds from their qualified plan account and pay ordinary income taxation on only the purchase price [cost]associated with the company shares or bonds, not the current fair market value of the company shares or bonds when they are distributed from the plan. The difference between fair market value and cost is called the net unrealized appreciation [or NUA.]. The plan participant can elect to defer the tax on the net unrealized appreciation until they make the decision  to sell that company stock or bonds. When the appreciated are finally sold, the former participant pays capital gains taxes, not ordinary income taxes, on the sales proceeds. Often the advice is to roll the non-company assets into a rollover IRA, and to retain the company distributed stock and bonds outside any IRA. To qualify for the tax deferral on the net unrealized appreciation the participant must take a lump sum distribution of all accounts held with their former employer- a partial distribution will not qualify. So it’s a pretty big deal to have the opportunity to pay capital gains taxes, not ordinary income taxes, on distributions of company stocks and bonds from  a qualified plan, and to be able to choose when to recognize the capital gains upon a sale. But what if the retiring plan participant takes a lump sum distribution from their qualified plan, satisfying the lump sum ‘rule’,  and they roll the entire distribution into a rollover IRA? If that occurs then the former participant has blown the opportunity to have the company stock or bonds taxed as capital gains. Once the company stock is rolled into an IRA this unique tax treatment for company stock and bonds is lost forever- the IRA owner will have to pay tax on all distributions from that rollover IRA at ordinary income tax rates [39.6%?], not capital gains tax rates [20%].

No one ever said the IRA distribution rules were easy to understand. Perhaps a more dangerous assumption that many make is that mistakes made in implementing the technical IRA rules can be easily fixed. That is not the case; some mistakes are without any remedies.