An entire IRA was lost to a distribution error after death. This is a textbook case of what not to do when a trust is named as the IRA beneficiary. Trusts are set up to protect assets, such as individual retirement accounts, after death, but if the rules are not followed precisely, an IRA can mistakenly be distributed and taxed too soon.
In Private Letter Ruling 201425023, released June 20, the Internal Revenue Service ruled that a surviving spouse who received IRA proceeds through a trust, which was the beneficiary of her deceased husband's IRA, could not roll over the IRA funds she received because more than 60 days had passed since the trust received the funds. The IRS denied her request for more time to do the rollover because she didn't provide sufficient proof of financial institution error.
“Ben” had an IRA and named a trust as his beneficiary. The trustees of the trust were his two children. His wife, “Ann,” was a partial trust beneficiary. Part of the trust called for Ann to receive 25% of the value of Ben's IRA as a distribution from the trust.
After Ben died, instead of a properly titled inherited IRA for the trust being set up and distributing out the applicable 25% to Ann, the entire proceeds of the IRA were distributed out to the trust and ultimately deposited into the trust's non-IRA checking account. That triggered taxes on the distribution, an error that cannot be corrected since the trust is a nonspouse beneficiary. A nonspouse beneficiary can never do a rollover, which would be the only way to correct this mistaken distribution (other than the spousal rollover for her share, which was denied in this case).
Since the IRS denied Ann's spousal rollover request, the money she received from the trust and then deposited into her own IRA was not eligible for rollover. This also meant that Ann's portion of the inherited IRA distribution was taxable as a regular contribution for 2009. Assuming the deposit was more than $6,000 (the IRA contribution limit for 2009 for someone age 50+) and that Ann was not 701/2 or older that year, then any amount above $6,000 was automatically treated as an excess IRA contribution. If an excess contribution is not removed by Oct. 15 of the year after the deposit, it is subject to a 6% penalty each year until it's corrected.
The 6% excess contribution penalty is reported on IRS Form 5329. When Form 5329 is not filed, the statute of limitations (normally three years) never begins to run, potentially adding more penalties and interest to an already costly situation.
While there are many good reasons to name a trust as the beneficiary of an IRA, the main reason is for post-death control and protection. If IRA owners wants to control how the funds are paid out after they die, a trust can do that. The IRA owner tried to do that here, but bad advice and a misunderstanding of the IRA tax rules while implementing the plan after Ben's death negated the intent of his estate plan.
Trusts are often named as an IRA beneficiary for creditor protection purposes. In light of the June Supreme Court ruling in the Clark case, in which the court ruled that inherited IRAs are not protected in bankruptcy under federal law, more IRA owners may consider naming a trust as the beneficiary of their IRA to protect the money from a beneficiary's creditors.
Trusts are complicated. The IRA required minimum distribution rules are complicated, too. When you mix the two by naming a trust as an IRA beneficiary, problems often occur.
After the IRA owner dies, paying out the entire inherited IRA to the trust should NOT be done, unless the trust says so — and if, in fact, the trust says so, it's generally a pretty useless and unnecessary trust. Under the tax rules, only the required minimum distribution needs to be paid to the trust, not the entire balance. Additional funds can be paid out, though, depending on the trust terms.
But anything paid out generally will be taxable and cannot be returned to the inherited IRA, even if the entire IRA is paid out to the trust in error. This was the case in a 2005 ruling (PLR 200513032) in which an entire inherited IRA was mistakenly paid out to the trust, triggering taxation and ending the inherited IRA. IRS denied 60-day rollover relief here, as well.
Once inherited IRA funds are distributed to a nonspouse beneficiary, the tax shelter is terminated and the distribution is taxable.
Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group. He can be reached at irahelp.com.