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Distributions and "Undistributions"

Two recent letter rulings show that 'distribution' is a flexible term.

Natalie Choate, 11/09/2012

Many tax effects hinge on receiving a "distribution" from a retirement plan. Two recent letter rulings show that "distribution" is a flexible term, that money can be "undistributed," and that even I can be wrong sometimes.

Question: Can a distribution be "undistributed"?
Sean inherited a 401(k) plan from his mother. Sean sent the plan administrator properly filled out forms instructing the administrator to transfer the inherited 401(k) account to an "inherited IRA" (Account #123) that Sean had previously opened at XYZ Bank to receive these funds. The 401(k) account was properly titled "Sean, as beneficiary of Mother." The IRA Account #123 was also properly titled "Sean, as beneficiary of Mother." Sean also has a taxable checking account at XYZ Bank (Account #456). XYZ Bank, due to a clerical error, deposited the funds into Sean's taxable checking Account #456 instead of into the inherited IRA Account #123.

Can this mistake be fixed, or is Sean stuck with a 100% distribution of this inherited retirement plan?

Answer: Yes--sometimes!
Once upon a time I would have said Sean has no remedy other than a possible claim against XYZ Bank for its negligence. I thought that once funds have been distributed out of a retirement plan to a nonspouse beneficiary, there is no way to get the funds into another plan or even back into the same plan. You see, I believed that once money was "out" of a retirement plan, it could not get back "in" to a retirement plan unless it was an eligible rollover distribution, and distributions to nonspouse beneficiaries are never eligible rollover distributions. Nonspouse beneficiaries can have a direct trustee-to-trustee transfer from an inherited plan to an inherited IRA but cannot use the "60-day rollover" method.

How wrong I was. Apparently there is another pathway used by savvy practitioners, plan administrators, and IRA providers--a path I call undistributing the distribution!

My change of viewpoint started when the IRS issued Private Letter Ruling 2011-39011, in which a father had died leaving his qualified retirement plan benefits to his minor child. The child's mother was appointed as guardian of the child. The retirement plan benefit was eligible for a "nonspouse beneficiary rollover" (i.e., a direct trustee-to-trustee transfer into an inherited IRA). Instead of arranging such a transfer, however, the mother-guardian requested a lump sum distribution on the child's behalf. The distribution was reported on the child's 2008 income tax return, and income tax was paid on it.

Apparently, the mother misused some or all of the child's funds. A new conservator was appointed, who obtained a court order compelling the mother to pay back the misappropriated funds. Because "But for the decision by [the mother/guardian] to receive a lump sum distribution...and her subsequent misuse of the funds" a tax-free transfer "could have been made to an inherited IRA," the IRS ruled that the funds could now be transferred into an inherited IRA, the child's income tax return for 2008 could be amended to erase the reported lump sum distribution, and the child could get a refund of the income taxes paid!

In effect, the IRS permitted a "late rollover" of the distribution. The IRS doesn't mention the 60-day deadline hardship waiver procedure for good reason--the distribution wasn't eligible for a 60-day rollover, so there is no "deadline" to be waived!

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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