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“Makeup” required minimum distributions salvage lifetime payouts to nonspouse IRA beneficiary

Mike Habib, EA

A private letter ruling allows the nonspouse beneficiary of an IRA to salvage lifetime payouts even though she failed an essential rule requiring distributions to begin by the end of the year following the year of the IRA owner’s death. She made up missed annual required minimum distributions (RMDs) and paid a penalty excise tax, but by doing so she avoided a tough 5-year payout rule.

Background. If an IRA owner dies before his required beginning date (RBD), namely Apr. 1 of the year following the year in which age 70 1/2; is attained, then as a general rule his entire interest must be distributed within 5 years of his death. (Code Sec. 401(a)(9)(B)(ii)) However, if any part of the IRA is (1) payable to (or for the benefit of) a designated beneficiary, (2) that part is to be distributed under regs over the life or life expectancy of the designated beneficiary, and (3) the distributions begin not later than 1 year after the date of the deceased’s death (or a later date as prescribed by regs), then that part is treated, for Code Sec. 401(a)(9)(B)(ii) purposes, as paid out when distributions commence. (Code Sec. 401(a)(9)(B)(iii))

Reg. § 1.401(a)(9)-3, Q&A 3(a), says that where there’s a nonspouse beneficiary for the IRA (or a qualified plan account), in order to satisfy the life expectancy payout rule in Code Sec. 401(a)(9)(B)(iii), “distributions must commence on or before the end of the calendar year immediately following the calendar year in which the [IRA owner or employee] died.”

The determination of whether the five-year or lifetime payout rule applies depends on the provisions of the IRA. It may be silent as to which rule (5-year or lifetime payout) applies, specify which rule applies, or it may allow the owner (or beneficiary) to elect which rule applies. (Reg. § 1.401(a)(9)-3, Q&A 4)

    (1) If the IRA does not contain one of the optional provisions described in (2) or (3), below, specifying the methods of distribution if an IRA owner dies before required distributions begin, then payouts are made over the life of the designated beneficiary (or over a period which doesn’t extend beyond the life expectancy of the designated beneficiary). (Reg. § 1.401(a)(9)-3, Q&A 4(a)(1)) The lifetime payout also applies if neither IRA owner nor beneficiary make the choice in (3), below. (Reg. § 1.401(a)(9)-3, Q&A 4(c))

    (2) The IRA may adopt a provision specifying either that (a) the 5-year payout rule applies to certain distributions even if there’s a designated beneficiary for the IRA, or (b) that payouts in every case will be made under the 5-year rule. (Reg. § 1.401(a)(9)-3, Q&A 4(b))

    (3) The IRA may allow the owner or beneficiary to choose between a 5-year or lifetime payout and may specify one or the other payout method if the choice isn’t timely made. (Reg. § 1.401(a)(9)-3, Q&A 4(c)) Where the IRA calls for a choice to be made between 5-year and lifetime payouts, it must be made by the earlier of:

  • Dec. 31 of the calendar year in which the distribution would have to start in order to meet the lifetime payout rule under Code Sec. 401(a)(9)(B)(iii) and Code Sec. 401(a)(9)(B)(iv) (i.e., for nonspouse beneficiaries, by Dec. 31 of the year following the year of the IRA owner’s death), or
  • Dec. 31 of the calendar year that includes the fifth anniversary of the IRA owner’s death. (Reg. § 1.401(a)(9)-3, Q&A 4(c))

Any failure (by the IRA owner or beneficiary) to take the RMD for a tax year is subject to an excise tax equal to 50% of the amount by which the RMD exceeds the actual amount distributed during the tax year. (Code Sec. 4974(a))

Facts. A taxpayer we’ll call Rachel Smith is the only child of a taxpayer we’ll call Leonard Smith, who died in 2002 when he was 66 years old. Rachel, named as the sole beneficiary of Leonard’s IRA X and IRA Y, was 30 years old when Leonard died. After Leonard’s death, the IRAs were retitled “IRA X- Leonard Smith, Decedent IRA, Rachel Smith, Beneficiary,” and “IRA Z (formerly IRA Y), Leonard Smith, Decedent IRA, Rachel Smith, Beneficiary.” No distributions were made from either IRA in connection with their retitling.

IRA X provides, that where a required distribution has not commenced before the owner’s death, the balance of the IRA must be distributed to the owner’s nonspouse designated beneficiary over his or her life expectancy starting by Dec. 31 of the year following the year of the IRA owner’s death. A nonspouse beneficiary may elect to receive distributions in accordance with the 5-year rule. IRA Y provides that if the owner dies before his RBD, his nonspouse beneficiary may receive distributions over his or her life expectancy beginning no later than the end of the year following the year of the IRA owner’s death. The nonspouse beneficiary may choose to receive RMDs in accordance with the 5-year rule.

Rachel should have, but failed to, start taking RMDs over her life (or life expectancy) for 2003 (the year after her father died), and for 2004. However, the RMDs for 2003, 2004, and 2005 were taken in the aggregate in 2005, based on Rachel’s life expectancy for each year using the distribution period spelled out in Reg. § 1.401(a)(9)-5 , Q& A 5(c)(1). In 2007, Rachel paid the Code Sec. 4974(a) penalty tax for her failure to timely receive RMDs for 2003 and 2004. The ruling says that Rachel represented, and evidence submitted in conjunction with the ruling request supported the representation, that she had not elected the Code Sec. 401(a)(9)(B)(ii) 5-year distribution rule for either IRA X or IRA Y (as retitled).

The essential question in PLR 200811028, was whether Rachel’s failure to timely take RMDs for 2003 and 2004 resulted in her having to receive the balance from the two IRAs under the 5-year rule, or whether she could take RMDs from the IRAs over her life or life expectancy.

Favorable ruling. IRS concluded that Rachel could take RMDs from the two IRAs for 2003 through 2006, and all subsequent years, over her life expectancy. IRS reasoned that the “default” required distribution rule for both IRAs where the owner dies before his RMD and has designated a beneficiary is the life-expectancy rule and not the 5-year rule. In Rachel’s case both IRAs provide that where an IRA owner dies before his RMD, distributions to a beneficiary are to be made under the life-expectancy rule unless the designated beneficiary chooses otherwise. Rachel hasn’t elected the 5-year rule for either IRA and has paid the 50% excise tax on the distributions she should have but didn’t receive in 2003 and 2004. Thus, IRS concluded that “the life-expectancy rule of Code Sec. 401(a)(9)(B)(iii) , the “default” rule, applies to distributions from both IRA X and IRA Y.”

    Observation: PLR 200811028 arrives at an extremely favorable result. It allows Rachel to spread out RMDs from the IRAs over 52.4 years (her life expectancy under the Single Life Table of Reg. § 1.401(a)(9)-9, Q&A 1, for the year following the year of her father’s death), and to keep the tax-deferred earnings feature of the IRAs alive for that period of time. Had IRS ruled that the 5-year payout rule was triggered by her failure to timely begin making distributions, she would have had to deplete both IRAs by Dec. 31, 2007 (the end of the calendar year containing the fifth anniversary of Leonard’s death).

    Observation: Although private letter rulings can’t be relied on by a taxpayer other than the one who requested it, those who are in a situation like Rachel’s would appear to be in a strong position to request similar, favorable treatment from IRS.

    Observation: The ruling illustrates the hazards of not receiving expert tax advice when dealing with post-death IRA distributions. In Rachel’s case, she wound up having to take three-years’ worth of RMDs in one year, quite possibly having to pay a higher marginal tax rate and claiming smaller writeoffs for deductions that are subject to AGI-based phaseouts, and paying a 50% excise tax to boot.