A recent Tax Court Decision came across my desk the other day that acts as a reminder that making a spousal rollover of a decedent spouse’s IRA is sometimes not the ‘no brainer’ decision that clients and advisors often ascribe to it.

In Susanne D. Oster Ozimkoski, T.C. Memo, 2016-228 (December 19, 2016) the Husband died in 2006 when he was 62 years old. His Will pretty much left everything to his Wife. Part of Husband’s estate was a $235,000 IRA maintained at Wachovia. Husband also owned a home that he purchased a couple of years earlier for $185,000 and he had other probate assets of another $75,000. Husband did not name a beneficiary for his IRA. Wife was age 51 when her husband died. A Son from Husband’s prior marriage contested his father’s Will. Wachovia froze Husband’s IRA pending the outcome of the Will contest. An out-of-court settlement was reached between Wife and Son in 2008 to resolve  the Will contest. It was agreed that Son would  receive $110,000 free from any taxes, and a motorcycle (gotta love boys and their toys.) After that settlement with Son Wife transferred $235,495 from Husband’s IRA to her own IRA with Wachovia’s blessing.  Wife then pulled roughly $142,000 from the IRA and wrote a personal check to Son for $110,000 in satisfaction of their Will contest settlement agreement. In total, Wife pulled $174, 500 in distributions from ‘her’ IRA in 2008. No surprise, Wachovia issued a 1099-R to Wife, but Wife did not report any of that distribution to her on her Form 1040 return for 2008. Also no surprise, the IRS then dinged Wife for a 10% penalty for early distributions [she was not yet 59.5 years old] and then a late filing penalty and an accuracy related penalty to boot. Wife argued unsuccessfully to the Tax Court that Son was entitled to receive the $110,000 from the probate estate, and thus that it was not her asset. The Tax Court found that the penalty for early withdrawals was appropriate, and also the late filing penalty was also sustained.  Somewhat of a surprise, however, was that the Tax Court found that Wife had reasonable cause and that she had acted in good faith in not reporting the $110,000 that she used to pay Son, so the Tax Court did not impose an accuracy related penalty on Wife.

The Tax Court noted that Wachovia should have distributed the IRA to Husband’s estate, and that the amount was incorrectly rolled by Wachovia into Wife’s IRA. The Tax Court also said that it had no jurisdiction to unwind the rollover to Wife, and that once the distributions were made, they were then taxable.

What is unclear is why the Tax Court found that Wife could not have been able to rollover Husband’s IRA benefits, since they were payable to Husband’s estate, and Wife was the sole beneficiary of Husband’s estate. The IRS has frequently held in private letter rulings that if retirement account or IRA assets are paid to the participant’s or IRA owner’s estate, and the entire estate is payable to the owner’s surviving spouse, the surviving spouse may nonetheless roll the assets into his/her own IRA. Apparently that analysis was not argued by Wife to the Tax Court.

Obviously when Wife negotiated with Son, she should have factored into the amount that she agreed he was to receive the income tax consequences associated with taking the money from the IRA to be used to pay the $110,000. Or,  she should have negotiated a direct payment of a part of the IRA directly to Son of the negotiated amount, so as to avoid her paying all of the income taxes (and penalties) associated with that IRA withdrawal.

Ozimkoski is one of those unfortunate decisions where some bad facts [no designated beneficiary] can lead to a bad outcome [immediate income taxes and penalties imposed.]

But what if Husband had named Wife as the beneficiary of his IRA? Sometimes a spousal rollover is not always the best advice to give to the surviving spouse. The pros and cons for spousal rollovers can be summarized by looking at some of the facts in this Tax Court decision.

  1. If Wife had been named as the beneficiary of Husband’s IRA, she could have rolled over the entire $235,000 into her own IRA. With that step Wife could have deferred any required distributions until her required beginning date, roughly 19  years after Husband’s death- until April 1 after Wife turned 70.5 years. With her own rollover IRA Wife could then name new beneficiaries for her IRA [obviously not including Son!], she could thus obtain a longer stretch for when distributions would have to begin. Wife could  also have converted her rollover IRA to an income tax-free Roth IRA. Because of this flexibility, most surviving spouse’s opt to make a rollover to their own IRA. But the IRA, even if rolled over, was still the only source of funds, apparently, that could be used to pay Son the negotiated amount to end the Will contest, so she still would have been stuck with income taxes and a 10% early distribution penalty.
  2. Since Wife was in her early 50’s, she might have needed the money having lost her Husband.  If Wife decided to roll over Husband’s IRA into her own IRA, Wife would then be exposed to the 10% penalty for taking early distributions prior to her attaining age 59.5 years. Had Wife left the IRA intact as Husband’s IRA, and she took distributions from Husband’s inherited IRA for her own benefit [not from her own rollover IRA] Wife would not have to pay a 10% early distribution penalty. One of the statutory exceptions to the 10% early distribution penalty is for distributions that are taken after the death of the IRA owner from an inherited IRA by his spouse. Consequently, Wife’s possible need for financial resources to live on might dictate that she continue as the designated beneficiary of Husband’s inherited IRA as opposed to rolling its assets and adding them to her own IRA.
  3. What if Husband had named Wife as his IRA beneficiary and she decided to not roll over the assets into her own rollover IRA. Perhaps she felt that she would not need to access the assets, but she is not all that sure, and the threat of a 10% penalty mades her think twice about taking a rollover IRA. Yet another special rule for surviving spouses deals with taking required minimum distributions from inherited IRAs. If Husband had named Son as his IRA beneficiary Son could have taken distributions from his inherited IRA over son’s life expectancy, but beginning no later than December 31 of the year following the Husband-Father’s death. But if Husband had named Wife as the beneficiary of his IRA, and Wife opted to not roll the assets into her own IRA, and instead remain as the designed beneficiary of Husband’s inherited IRA, Wife (unlike Son) could delay taking any distributions from Husband’s IRA until Husband would have attained age 70.5 years. In this case, since Husband was age 62 when he died, there was another 8 years that had to pass before Wife would have to begin taking required minimum distributions from her Husband’s inherited
  4. One last special rule that was created for a surviving spouse who opts to continue with her late Husband’s inherited IRA where she remains as its beneficiary is if Wife dies before the date Husband would have reached age 70.5 (in the next 8 years) Wife’s designated beneficiaries of Husband’s inherited IRA could take distributions from that IRA over her beneficiary’s own life expectancy, as if the surviving spouse (Wife) had rolled the entire IRA over into her own rollover In contrast, had Son been named Husband-Father’s IRA beneficiary and he died while taking required minimum distributions, Son’s designated beneficiaries of his inherited IRA must continue to take distributions from the IRA over Son’s normal life expectancy period.

Some key take-aways follow:

  1. If Husband dies before age 70.5 and Wife is under age 59.5, Wife generally should remain as the designated beneficiary of Husband’s inherited IRA, and not roll the benefits into her own rollover Thus, Wife can take distributions without incurring the 10% penalty on early distributions, but she need not take any distributions.
  2. If we are talking about a qualified plan account, e.g. 401k, and not an IRA, Wife can roll the decedent’s retirement account into an IRA that is created in the name of deceased Husband, naming herself as the beneficiary of deceased Husband’s IRA.
  3. When Husband would have attained age 70.5 (8 years after his death) and Wife attains age 59.5 years, Wife can then roll the assets from Husband’s inherited IRA into Wife’s own rollover
  4. If Husband died after he attained age 70.5 and Wife was then over the age of 59.5 years, then Wife should roll the assets from Husband’s IRA into Wife’s own rollover Then Wife can name her own beneficiaries, possibly gain a stretch in distributions over a longer period, and possibly convert the rollover IRA into a Roth IRA.
  5. The toughest decision for the Wife is when Husband would have reached age 70.5 and Wife is still under the age 59.5 years. At that point Wife has to make a decision. Either she decides to roll the IRA assets into her own rollover IRA [possibly exposing them to the 10% early distribution penalty if she needs to take a distribution to support herself] or she decides to continue on as the designated beneficiary of the inherited IRA that Husband left for her; Wife would have to start to take distributions from Husband’s inherited IRA but at least those distributions would not be exposed to a 10% penalty tax for early distributions.
  6. Or, Wife assesses her financial circumstances and estimates how much she may need from Husband’s IRA to support herself until she reaches age 59.5. She then rolls the excess over that identified amount of Husband’s IRA assets into Wife’s rollover She continues to take distributions from Husband’s inherited IRA, and pays the income tax, but not the 10% penalty on early distributions, and she leaves the balance in her own rollover IRA which she is then free to convert to a Roth IRA, or at least she is able to name her own beneficiaries of her rollover IRA.

The moral of this story is that before you make a knee-jerk decision to advise a surviving widow to make a rollover of her late husband’s IRA into her own rollover IRA, you first need to consider to her age, the age of her late husband, and her cash flow needs for several years after her husband death. A partial rollover may be the answer that best meets the needs of the survivor.