In a pair of recently decided private letter rulings, the IRS unexpectedly blessed tax-free rollover treatment in situations where spouses inherited IRAs that did not actually designate them as beneficiaries.
The rulings were surprising because, in completing the rollovers, these IRA funds passed through trusts that did not technically allow for the tax-free rollover treatment. While favorable rulings preserved the valuable IRA tax deferral for these surviving spouses, the results were by no means guaranteed, and the inconvenience of obtaining IRS rulings could have been avoided entirely had the taxpayers in these cases planned properly in the first place.
Private Letter Rulings 201430026 and 201430029: The Facts
Both of these recent Private Letter Rulings (PLRs) involved cases where a deceased spouse named the surviving spouse’s trust—rather than the surviving spouse herself—as designated beneficiary of the IRA. When each IRA owner died before reaching age 70½, the IRA funds were distributed into each of the surviving spouse’s trusts. The surviving spouses then attempted to roll those funds into their own IRAs, a technique that would have been easily accomplished had the surviving spouses themselves been designated IRA beneficiaries.
The general rule governing inherited IRA funds that are paid into a trust provides that the surviving spouse is no longer eligible to roll those funds into an IRA in his or her own name once the trustee actually distributes the proceeds to that trust. In such a case, the surviving spouse is treated as though he or she received the proceeds from the trust, rather than from the deceased spouse’s IRA.
However, the IRS found that this general rule does not apply when the funds are considered to have been distributed to the surviving spouse only because he or she is named as sole trustee of the trust that received the IRA proceeds.
In each of these PLRs, the surviving spouse was sole trustee and had the power to control trust payments, add trust property, or amend or revoke the trust. Therefore, the IRS exempted them from the general rule and allowed them to roll the IRA proceeds from the trust into their own IRAs within 60 days without incurring income tax liability.
The Surprise Ruling
The results in these cases were surprising because neither of the trusts would qualify as see-through trusts that could be looked through to use the trust’s beneficiary as the IRA designated beneficiary. Therefore, the rules governing nondesignated beneficiaries could have applied to prevent tax-free rollover treatment.
Generally, if IRA proceeds pass to a designated beneficiary, the life expectancy of that designated beneficiary can be used to stretch withdrawals from the inherited IRA over the beneficiary’s lifetime. Similarly, if IRA proceeds pass to a nondesignated beneficiary after the original account owner has begun taking required minimum distributions (RMDs), the remainder of the account proceeds can be distributed based on the life expectancy of the original owner. However, if the proceeds pass to a nondesignated beneficiary before RMDs have begun, the IRS can require that the entire account balance be distributed within five years of the original owner’s death.
In this case, because the original account owner’s RMDs had yet to begin and the designated beneficiaries were trusts (which have no life expectancies), but not see-through trusts where the trust beneficiary’s life expectancy can be used, the IRS could have prohibited the rollover treatment that allowed the IRA proceeds to be distributed over the lives of the surviving spouses.
Proper Planning Strategy
The time and expense of obtaining a favorable IRS ruling could have been avoided if the deceased spouses had simply designated their spouses directly as beneficiaries under the IRAs. In the alternative, the designated beneficiaries could have been trusts that qualified as see-through trusts.
In order to qualify as a see-through trust, four requirements generally apply:
- the trust must be valid under state law
- the trust must be irrevocable (or must become irrevocable upon the death of the IRA owner)
- the trust beneficiaries must be identifiable
- a copy of the trust must be provided to the IRA custodian by October 31 of the year after the IRA owner’s year of death.
The trusts here were revocable by the surviving spouses, so they failed to meet the second requirement, which forced the surviving spouses to turn to the IRS to approve the tax-free rollover treatment.
The surviving taxpayers in these cases stood to lose thousands in immediate income tax liability had the IRS decided that tax-free rollover treatment was impermissible. While the IRS eventually ruled in their favor, advisors should note that simple advance planning could have prevented the question entirely had the designated beneficiary forms been properly prepared.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
To find out more, visit http://info.nationalunderwriteradvancedmarkets.com. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.