Financial advisers should be aware of a new IRS ruling that recently saved the day for an IRA beneficiary and may help your clients.
The decision involved a "stretch individual retirement account," which allows a designated IRA beneficiary — the person named as the beneficiary on the IRA beneficiary form or through a default provision in the IRA custodial agreement — to extend distributions over his or her lifetime rather than over a shorter, less favorable payout period. A designated beneficiary must be a person or a "see-through" or "look-through" trust.
To take advantage of the stretch IRA payout, the beneficiary simply has to take required minimum distributions, or RMDs, beginning in the year after the IRA owner's death.
But what if the beneficiary misses a required distribution? Do they lose the stretch IRA and default to less favorable rules, such as the five-year rule?
In a recent private-letter ruling (PLR200811028), the Internal Revenue Service stated that the designated beneficiary won't lose the stretch provisions.
In this case, the IRA owner died in 2002 at age 66 before his required beginning date and before taking any distributions. His daughter was the sole named beneficiary on his two IRAs. In 2003, the year after her father's death (when RMDs would have had to begin), the daughter was 31 and her life expectancy for the stretch IRA was 52.4 years.
After inheriting the two IRAs, the daughter set them up as properly titled inherited IRAs in the name of the deceased IRA owner. She neglected to take her RMDs for 2003 and 2004 but in 2005 took RMDs for all three years (2003, 2004 and 2005) to make up for what she missed. She did not elect to use the five-year distribution rule and took the RMDs based on her life expectancy. In 2007, she paid the 50% penalty for the missed 2003 and 2004 RMDs.
The daughter requested this private-letter ruling from the IRS in order to know for sure if the fact that she neglected to take the 2003 and 2004 RMDs in a timely way would nullify the stretch IRA for her and force her to default to the five-year rule.
The IRS ruled in her favor, stating that missing RMDs do not cause the beneficiary to default to the five-year rule. The fact that the custodial agreements on both IRAs stated that the inherited IRA was to be paid out under the life expectancy method was helpful to her.
Although a private-letter ruling is authoritative only for the person who requested it, this ruling provides guidance on how the IRS would rule in similar cases, and there are probably many beneficiaries who forget or are unaware that they are subject to RMDs when they inherit an IRA. The favorable ruling made it clear that the stretch IRA is the default when there is a designated beneficiary.
The IRS also pointed out that the IRA custodial agreement for each of the IRAs required the life expectancy payout. This means that if the IRA custodial agreement had said that the five-year rule applied — even though the law clearly does not say that — it is likely that the beneficiary would be stuck with that rule.
Since tax regulations default to the stretch IRA for a designated beneficiary, it is likely that most IRA custodial agreements will do the same. But there is no guarantee. That is why advisers should check the IRA custodial agreements for all IRAs they manage.
Some financial institutions restrict beneficiary options and might not allow the stretch IRA. The time to check that is while the client is still living; it's too expensive to request a private-letter ruling after the fact.
Although the 50% penalty clearly applies to all missed RMDs, it is not clear why there was no request to have this penalty waived. In most cases the IRS will waive the penalty for reasonable cause, especially when the missed RMDs are made up as was the case here. Reasonable cause could easily include not knowing that a distribution was required, and many beneficiaries do not know this.
In this case, it appears that the penalty was paid to avoid defaulting to the five-year rule. In any case, advisers should always request a waiver of the 50% penalty when RMDs are missed. But the missed RMDs must be made up, and future RMDs must be withdrawn in a timely manner.
Ed Slott, a certified public accountant in Rockville Centre, N.Y., also has created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
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