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Inherited IRA Problems

Problems often begin after the IRA owner dies, as these readers can attest.

Natalie Choate, 04/13/2012

What do practitioners say about Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011)? "I sleep with your book under my pillow." "We regard your book as the ultimate authority." "I wish more people wrote books the way you do." "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "It's paid for itself already." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about Life and Death Planning for Retirement Benefits, visit www.ataxplan.com.

Question: Father died in 2008 leaving his IRA to son, who is age 50. Son began taking a life expectancy payout from the inherited IRA. Now mother has died in 2012, and she also left her IRA to son. Since both accounts have the same beneficiary, and son is going to take a life expectancy payout from both accounts, can he combine them? It would be much easier for him to have only one inherited IRA and take only one annual minimum distribution than juggle two inherited IRAs and make two annual minimum distribution calculations.

Answer: Unfortunately, he can't do it. The IRS has decreed that, for minimum distribution and income tax purposes, an IRA inherited from one individual cannot be combined with an IRA inherited from a different individual--even if it's the same beneficiary who now owns both accounts.

Though this answer seems illogical, remember that even though the same beneficiary inherited both accounts, his Applicable Distribution Period (life expectancy) is actually different for the two accounts. Once you inherit an IRA, your life expectancy for that inherited account becomes "carved in stone": It is determined based on your age in the year after the year of the participant's death, then it decreases by one full year each year. Meanwhile, however, your "real" life expectancy does not go down by one each year. Your real life expectancy keeps extending outward the longer you live--until you inherit another account, at which time your life expectancy, as a beneficiary, becomes frozen for the new account.

Son, the beneficiary, was born in 1950. Father died in 2008, so Son's first Distribution Year for the IRA inherited from Father was 2009, the year Son turned age 59. According to the IRS' Single Life Expectancy Table, Son's life expectancy for Father's IRA was 26.1 years in 2009, 25.1 in 2010, 24.1 in 2011, and 23.1 in 2012. Son's "divisor" (life expectancy or Applicable Distribution Period) for Father's IRA for the year 2013 will be 22.1.

Mother died in 2012. Son's first distribution year for Mother's IRA will be 2013, the year Son turns age 63, so Son's life expectancy (Applicable Distribution Period or divisor) for that account in 2013 will be 22.7, not 22.1!

(By the way, this business of a fixed or frozen life expectancy does not apply to the surviving spouse. A spouse who inherits benefits from her deceased spouse has two options that are not available to other beneficiaries. She can take a life expectancy payout with her life expectancy being recalculated (extended) every year, or she can roll the whole thing over to her own IRA and stop taking distributions as beneficiary altogether.)

If you don't like my answer, you can apply for an IRS ruling that it would be all right to combine the two accounts as long as Son uses the shorter Applicable Distribution Period for both accounts. The IRS has never commented on that specific approach. But I assume that applying for an IRS ruling (with attendant delay and expense) would be even more inconvenient than maintaining two separate IRAs with different distribution periods for the next 22 years, especially since there's no way to predict whether the IRS will go along with you.

If you do not obtain an advance IRS ruling blessing the merger, the risk of combining the two inherited IRAs is that one or both accounts might be disqualified (treated as distributed), so I would not recommend that you do this.

Question: Shortly before his death at age 89, Father moved his IRA from Bank X to Bank Y. The old account at Bank X had named Mother (his wife of more than 60 years) as sole beneficiary. He filled out the forms to open the new IRA at Bank Y, including naming Mother as beneficiary, but unfortunately he signed the form in the wrong place (he signed on the "spouse" line instead of the "participant" line). A clerk at Bank Y had him sign a whole new account opening form (prepared by the clerk), but neglected to complete the beneficiary designation part of the form. Nobody noticed this mistake; in the meantime, Father told everyone "My IRA goes to Mother," and the estate planning lawyer prepared a flow chart showing the IRA going to Mother. Now Father has died, the mistake has come to light, and Bank Y says they must pay the benefits to Father's estate as default beneficiary! Is there anything we can do to fix this?

Answer: There are three possible courses of action I can see:

1. In some cases if the IRA provider admits it made a mistake, it will correct the mistake. For example, if the IRA provider clearly was supposed to put "spouse" as the beneficiary and failed to do so, or changed the beneficiary designation without the participant's knowledge, they ought to fix the mistake and recognize that the spouse is the beneficiary.

2. Sometimes it's not clear exactly who made the mistake--the IRA provider, the participant himself, or the participant's estate planning attorney--but it is clear that the participant intended to name his spouse as beneficiary and thought he had done so. In that case, a state court might be willing to "reform" the beneficiary designation to say what it was supposed to say and what the decedent thought it said. This type of reformation would be binding on the IRA provider and even the IRS would probably accept it if there are bona fide grounds for "reformation." They did accept such a state court post-death reformation of a beneficiary designation form in similar circumstances in IRS Private Letter Rulings 200616039 and 200616040.

However, since those 2006 rulings were published, the IRS has become hostile to post-death reformations. The policy change came about because it appeared that some survivors would misuse reformation: Instead of using reformation to correct a paperwork error, some people tried to use it to design an entirely new, better estate plan. So this approach is not certain of IRS success, and it would be expensive, too.

3. Finally, if the spouse is the sole beneficiary of Father's estate, and the benefits are paid to the estate, she can roll over the benefits through the estate to her own IRA. This conclusion is based on a long line of IRS rulings establishing the principle that a surviving spouse can roll over, to her own IRA, benefits that pass to her as beneficiary of an estate or trust, provided certain conditions are met. In fact, you can even bypass the necessity of expensive and time-consuming probate proceedings by having a direct trustee-to-trustee transfer from Father's IRA to Mother's IRA, a procedure blessed by the IRS in a similar situation in Private Letter Ruling 201211034 (12/22/2011). See also the similar IRS Private Letter Ruling 200950058. The key to success with this approach is to find an IRA provider who will allow the IRA-to-IRA transfer without requiring an IRS ruling--perhaps an IRA provider willing to rely on a legal opinion (plus an attorney willing to provide the opinion).

Resources: For the IRS rules that you cannot combine IRAs inherited from different decedents, see Regs. § 1.408-8, A-9, § 1.408A-6, A-15, and § 1.403(b)-6(e)(7), and ¶ 1.5.09 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011; www.ataxplan.com) regarding minimum required distribution aspects; and see Rev. Proc. 89-52, 1989-1 CB 632, § 3.01; IRS Publication 590 (2011), Individual Retirement Arrangements (IRAs), "What if you inherit an IRA?," "IRAs with basis," p. 17; and ¶ 2.2.07 of Life and Death Planning for Retirement Benefits regarding income tax aspects.

Regarding post-death reformations, see ¶ 4.5.05–4.5.06 of Life and Death Planning for Retirement Benefits. For authority for the spousal rollover through an estate or trust, see ¶ 3.2.09 of Life and Death Planning for Retirement Benefits.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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