Here’s the hard truth: the rules concerning distribution of IRAs as part of inheritance are complex and inflexible. When heirs get the wrong advice, the results are disastrous. Few financial professionals, from bankers to mutual fund phone representatives really understand the rules. A recent article in Financial Planning, “When an inherited IRA becomes a tax nightmare,” relates a true story.
Florida resident Thomas W. Ozimkoski, Sr., died in August 2006. Seven months prior to his death, Ozimkoski executed a will that left most of his property to his wife Suzanne and named her as personal representative of his estate. Ozimkoski had a traditional IRA at Wachovia and a 1967 Harley Davidson motorcycle. A son from a prior marriage, Thomas, Jr., was unhappy about the will. Thomas went to probate court to fight his stepmother Suzanne. Wachovia Securities, the IRA custodian, froze the IRA funds pending the outcome of the litigation.
A settlement stipulated that Suzanne would pay Junior $110,000 and he’d get the motorcycle within 30 days of the date on which Senior’s IRA was unfrozen by Wachovia. The settlement also said that “all payments shall be net payments free of any tax.” The motorcycle transfer went smoothly, but not the payment of the IRA funds.
Wachovia transferred $235,495 from Senior’s IRA to one set up in Suzanne’s name. Suzanne took a distribution from her IRA and wrote a personal check for $110,000 to Junior to make the payment required in the settlement. She also took other distributions from her IRA that year totaling $174,597.
Wachovia issued a Form 1099-R showing taxable distributions of $174,597 to Suzanne that year, and her distributions were coded as early distributions because she took them from her own IRA and she was under 59½. Suzanne filed her 2008 federal income tax return late and reported only her wage income of $15,000, not any of the IRA distributions as income. The IRS came calling, issuing a notice of deficiency to Suzanne. They said she owed $62,185 in taxes and a 10% penalty on the IRA distributions. It also hit her with an accuracy-related penalty of $12,437. Suzanne brought her case to the Tax Court and represented herself. That’s never a good idea.
The Tax Court found that she owed income taxes, the 10% early distribution penalty and part of the accuracy penalty. The court agreed with the IRS that the distributions were taxable to Suzanne because they were from her own IRA.
The Tax Court noted that Wells Fargo, the successor to Wachovia, didn’t have Senior's IRA beneficiary designation form and no one knew whether it was never completed or somehow went missing. Without the form, the estate became the beneficiary by default. Because Suzanne inherited through the estate, the IRA became a probate asset, which can be subject to a will contest.
But if the beneficiary is named on the IRA beneficiary form, the account bypasses probate and goes directly to Suzanne. Because the estate—not Suzanne—was the beneficiary of the IRA, Wachovia “incorrectly” rolled it over to her IRA, said the court. What it should’ve done was distribute the IRA assets to Senior’s estate rather than to Suzanne’s IRA. The court said it couldn’t fix that mistake. The court expressed sympathy for Suzanne, but said it could not change the fact that the distributions she received were from her own IRA and, therefore, taxable income.
Things to keep in mind:
Beneficiary Forms. When Thomas Ozimkoski, Sr. updated his will to leave everything to his wife, he should’ve updated his IRA beneficiary designation form. If he did that, the IRA would have passed directly to her and never become part of the disputed probate estate. Any payment coming from an IRA will be taxable. If one party is not paying the tax, then someone else must. Naming a spouse on the beneficiary designation form lets her roll over the funds to her own IRA and avoids the result in this case.
An Experienced Attorney. Suzanne Ozimkoski lacked an attorney who understood the IRA rules. A knowledgeable estate planning attorney could have advised her better. A competent attorney would have seen Wachovia’s error and had the custodian reverse the transaction and retitle the inherited IRA properly.
Incorrect Rollovers. Suzanne could have elected to remain a beneficiary rather than do a spousal rollover. By remaining a beneficiary, the spouse could’ve taken the withdrawals she needed and avoided the 10% early distribution penalty.
The settlement agreement also stipulated that payments to Thomas were tax-free, but that too was wrong. There is no way to avoid a tax on IRA distributions, no matter what the agreement says. The Tax Court was not able to undo the rollover, and instead had to make a decision about the tax liability for Suzanne based on a wrongful transfer of the IRA assets to her own account and the distributions that she made.
The involvement of a knowledgeable estate planning attorney with experience in IRA distribution could have avoided this costly mess. If you have IRAs and have an estate plan and a will in place, close the loop by having a conversation with your spouse and adult children about making sure they know to work with qualified professionals to prevent this scenario from happening to your family.
Phew! What a complicated case! If we can take any advice from this predicament, it is that we should always check the beneficiary designations on our retirement accounts. It is also helpful to consult an attorney in regard to creating an estate plan. Also, using an Attorney for estate settlement could have helped the woman in this situation.
Reference: Financial Planning (February 17, 2017) “When an inherited IRA becomes a tax nightmare”