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

7-Oct-19

Spousal Rollovers

Take-Away: Assuming the SECURE Act passes, expected to be late this calendar year, there should be no impact on IRAs and qualified plans that name the owner’s surviving spouse as the beneficiary of the retirement account. However, a surviving spouse may be more inclined to make a qualified disclaimer of some of those inherited retirement assets as a result of the SECURE Act’s mandatory 10-year payout rule.

Background: Unlike most beneficiaries of retirement accounts, a surviving spouse has more than one option with regard to an inherited IRA. While the SECURE Act will force distributions from an inherited IRA over 10 years (maybe 5 if one of the other pieces of pending legislation is adopted) surviving spouses will be exempt from the 10-year (or 5-year) mandatory payout of the retirement account. While surviving spouses will continue under the ‘old regime’ for distributions, disclaimers of a portion of an inherited IRA by the surviving spouse may make more sense from an income tax perspective. A review of the current distribution options for a surviving spouse follows

Spousal Rollover: If a spouse is named as the primary beneficiary of a deceased spouse’s IRA or qualified plan account, the survivor can roll over that inherited IRA into their own IRA. The funds  held in the surviving spouse’s rollover are treated as if they were always held in the survivor’s IRA. In short, the surviving spouse will no longer treated as a beneficiary of those inherited IRA assets. The result is that by making the decedent’s IRA the survivor’s own IRA, no distribution will have to be taken from the rollover IRA until the survivor attains age 70 ½ (or age 72 if the SECURE Act becomes the law.) While deferring income taxation is a strong incentive for the surviving spouse to rollover the entire inherited IRA, there are a couple drawbacks.

  • Spousal Rollover Limitations: To start with, if the surviving spouse will need to access the rollover funds, and the survivor is under age 59 ½, then any distribution from the rollover IRA will be subject to the 10% excise tax assessed on an early distribution (from the survivor’s own IRA.) In addition, if the rollover funds are commingled with the survivor’s own IRA, there is a risk that if the survivor later files for bankruptcy, the entire amount held in the survivor’s IRA may not be exempt in those bankruptcy proceedings; Bankruptcy Courts have distinguished (protected) one’s own contributions to an IRA from an IRA that holds contributions made by their former/now deceased spouse, when providing bankruptcy protection of up to $1.2 million of assets held in an IRA.
  • Example: Ted names his wife Alice as the primary beneficiary of Ted’s IRA. On Ted’s death, Alice rolls over the balance of Ted’s IRA to an IRA that is opened in Alice’s name alone. Alice can name her own beneficiaries of this rollover Alice will not have to take any distributions from her rollover IRA until she attains age 70 ½. If, however, Alice rolls over the funds from Ted’s IRA into her own IRA where those funds are commingled with Alice’s own contributions from her own earned income, and Alice later files for bankruptcy, there is a risk that the bankruptcy trustee will include the entire amount of Alice’s ‘consolidated’ IRA in Alice’s bankruptcy estate to be used to pay her creditors. Alice’s own contributions to her IRA will be protected, but the courts will probably treat Ted’s funds as not protected in bankruptcy. To avoid this risk, if Alice decides to roll over Ted’s IRA, she should open a separate IRA, so that she will end up with two IRA accounts, one that holds her own contributions, and the other that holds the funds that she rolled over from Ted’s IRA. Distributions, if taken, should first be from Alice’s separate rollover IRA since it would not be exempt if Alice later files for bankruptcy.

Inherited Spousal IRA: Other spousal beneficiaries are better served when they choose to treat their deceased spouse’s IRA as an inherited IRA. This might be the case when the inherited retirement funds may be needed to support the surviving spouse. There is no 10% excise tax imposed when a beneficiary, regardless of age, takes a required distribution from the inherited IRA. Moreover,  when the surviving spouse is named as the beneficiary of an inherited IRA (not rolled over) the survivor’s required minimum distribution (RMD) [unlike other inherited IRA beneficiaries] is not until the later of December 31 of the calendar year following the year of their spouse’s death or December 31 of the calendar year in which the deceased spouse would have attained age 70 ½. Additionally, when the survivor begins taking the distributions from their deceased spouse’s inherited IRA, he/she will use the favorable Uniform Lifetime Table to calculate their RMD, in contrast to other beneficiaries of inherited IRAs, who must use the Single Life Table to calculate their RMDs. This rule permits a surviving spouse to possibly delay taking an RMD for an extended period of time- possibly decades!

  • Example: Ted dies in 2019 at age 60 years. Alice, Ted’s wife, is currently age 55 years. If Alice decides to retain Ted’s retirement funds in Ted’s inherited IRA, e. there is no rollover of the funds to Alice’s own IRA, Alice will not need to take any required minimum distributions from Ted’s inherited IRA for ten and a half years- until the date Ted would have been age 70 ½.

Blended Approach: There is no reversal (or do-over) of a rollover decision once the surviving spouse makes the IRA rollover. However, treating the deceased spouse’s IRA as an inherited IRA can be reversed by the surviving spouse at a later date. The survivor may want to keep the deceased spouse’s funds in an inherited IRA when he/she is under age 59 ½ years in order to avoid incurring the 10% excise tax if needed funds are withdrawn from the inherited IRA. Once the surviving spouse attains age 59 ½, then he/she can make a spousal rollover after that age is attained when the early distribution excise tax is no longer an issue, and perhaps delay taking any further distributions until the surviving spouse attains age 70 ½ .

Estate or Trust as Beneficiary: Often a mistake is made when the IRA owner fails to name a beneficiary, or the owner’s spouse is the beneficiary of the owner’s estate or trust. The IRA owner assumes that the retirement account assets will indirectly make their way to the surviving spouse, after estate or trust administration,  and thus be available for either a rollover or be subject to stretch distributions over the survivor’s life expectancy. A spouse who inherits through an estate or trust is not automatically entitled to either make a rollover or treat the deceased spouse’s IRA as an inherited IRA. Despite that general rule,  multiple private letter rulings are issued each year by the IRS, at significant expense and delay, in an attempt to move the decedent’s IRA assets into a position where they are subject to the surviving spouse’s rollover. While the IRS in recent months appears to be a bit more cooperative in granting private letter rulings to position the IRA to permit a spousal rollover, not to be overlooked is the legal expense and $10,000 IRS private letter ruling request fee. In short, it is best to name the spouse directly as the primary beneficiary of the deceased spouse’s IRA or retirement account.

SECURE Act Implications: As noted in last week’s summaries of the SECURE Act, while many spouses will continue to name their survivor as their primary beneficiary of their IRA, it may make sense to name others, e.g. children, as the primary beneficiaries, in part, in order to avoid exposing the combined retirement accounts of both spouses to a mandatory 10-year payout when the surviving spouse (parent) dies. The goal is to expose each spouse’s retirement accounts to separate 10-year payouts rather than a single 10-year payout on the death of the surviving spouse. If the spouses are uncomfortable not naming each other as primary beneficiaries of their retirement accounts, then they should name children as contingent or successor beneficiaries of their retirement accounts, since a qualified disclaimer by the surviving spouse of some, or all, of the deceased spouse’s retirement account would permit a portion of the deceased spouse/parent’s retirement account to be exposed to two 10-year payouts (first, when the owner dies, and another when the surviving spouse dies, assuming he/she did not consume their rollover IRA.

Successor Beneficiaries- The Last Word: With an inherited IRA, a beneficiary of that IRA can name their own beneficiaries should they not survive the payout period, either the RMD that uses their own life expectancy under current rules, or the 10-year payout rule if the SECURE Act becomes the law. By naming a successor beneficiary, the beneficiary enables the maximum stretch to continue into the next generation, ignoring the SECURE Act’s probable change in RMDs. When a beneficiary who is currently taking a stretch distribution dies before all the funds are withdrawn from their inherited IRA, then the successor beneficiary can continue taking RMDs based upon the first beneficiary’s life expectancy (again, ignoring for the moment if the SECURE Act passes.) The successor beneficiary cannot change the RMD method and use their own age to take RMDs. More to the point, even if the successor beneficiary inherits an inherited IRA from their spouse, he/she cannot do a spousal rollover. The successor beneficiary can name their own beneficiaries, but those successor beneficiaries will only be able to continue the initial stretch IRA distributions. They will not be able to make a rollover even if they are the surviving spouse of the named beneficiary of the inherited IRA.

  • Example: Ted names his wife Alice and their son David as successor beneficiaries of the IRA that Ted inherited from his mother, Roxanne. Ted dies while taking RMDs from the IRA that he inherited from Roxanne. On Ted’s death the inherited IRA is divided into two shares, one for Alice and the other for David. Both Alice and David will step into Ted’s shoes and continue to use Ted’s life expectancy to calculate their RMD’s from the inherited Alice cannot do a spousal rollover because she, Alice, is a successor beneficiary to Ted. If the SECURE Act becomes the law, then Ted will have an RMD period of no more than 10 years from Roxanne’s death. If Ted dies during that 10-year payout period, both Alice and David will stand in Ted’s shoes and take RMDs to complete that 10 years- they will not start over with their own 10-year payout period, even though Alice is Ted’s surviving spouse.

Conclusion: While the proposed SECURE Act exempts a surviving spouse from its 10-year payout rule, there are still plenty of decisions to make when a surviving spouse is named as the beneficiary of an IRA or qualified plan account: (i) rollover or (ii) treat it as an inherited IRA or (iii) disclaim  a portion of the deceased spouse’s retirement account. The more difficult may be the decision made by the surviving spouse to disclaim some of those retirement assets to avoid bunching all of the married couple’s  total retirement assets into the survivor’s name, in order to expose the inherited decedent’s retirement assets to two separate 10-year payouts as opposed to one 10-year payout when the survivor dies. While an IRA beneficiary designation form can be set up to contemplate a disclaimer by the surviving spouse, most surviving spouses are concerned about their financial security after the death of one spouse (and the loss of part of their social security retirement benefits) which makes the survivor’s disclaimer decision that much more difficult.