Income Tax Planning with Individual Retirement Accounts
We are occasionally faced with a situation where an IRA is designated to an individual that has predeceased the IRA owner with no contingent designated beneficiary named. In a situation where no designated beneficiary is named, the custodian agreement will control beneficiary designation and many times the IRA ends up payable to the estate of the deceased IRA owner.
Unfortunately, this situation can result in acceleration of the IRA payout term along with subjecting the IRA proceeds to taxation at the estate income rates. Estate income is currently subject to federal income taxation at the rate of thirty-seven percent (37%) on taxable income in excess of $13,050.00.
To avoid this result, taxpayers have attempted to redirect the IRA distribution directly to the deceased account owner’s heirs under their estate plan (his or her spouse or children), rather than to the estate. Historically, attempts to redirect the IRA to the deceased account owner’s heirs was met with resistance from both the IRS and the New Jersey Courts.
In regards to the latter cause of resistance, the New Jersey Courts, upon petition of the personal representative of the estate of the deceased IRA owner, would consider the redirection of the IRA directly to the decedent’s heirs. This would allow for the IRA to be rolled over and a beneficiary IRA established by an heir of the estate. The New Jersey Courts generally had to be involved since the IRA administrator was reluctant to distribute the IRA directly to the decedent’s heirs since this could subject the administrator to liability from the estate of the decedent.
Going forward, the New Jersey Courts may be receptive to a legal argument “redirecting” the IRA when advised of several private letter rulings involving situations where an IRA passes to an estate. The IRS has issued several private letter rulings that allow for redirection of an IRA after the death of the IRA owner. Two of these rulings are outlined below.
In Private Letter Ruling (“PLR”) 202031007 (released July 21, 2020), an IRA owner died after her Required Beginning Date (“RBD”) and before the SECURE Act was enacted. She left her IRA to her estate. Her estate was payable to the trust of which the personal representative was the trustee. The trust was payable to her children. The IRS allowed the personal representative to transfer the IRA to inherited IRAs for the children. The IRS didn’t require the personal representative to first transfer the inherited IRA to an inherited IRA for the trust, a step that wouldn’t have served any purpose. Note that the IRA owner could have avoided the need for a ruling by naming the children as the beneficiaries of the IRA. Because the IRA owner died before the SECURE Act, by naming the children as beneficiaries of the IRA, the children could have stretched the IRA over their life expectancies rather than over their mother’s remaining life expectancy as if she hadn’t died.
In PLR 202039002 (released Sept. 25, 2020), an IRA owner died after his RBD and before the SECURE Act was enacted. He left his IRA to his estate. The personal representative set up an inherited IRA for the estate. The IRS allowed the personal representative to distribute the IRA to inherited IRAs for the decedent’s partner, son and grandson, who were the beneficiaries of the estate. Again, the IRA owner could have avoided the need for a ruling by naming the beneficiaries of the estate as the beneficiaries of the IRA. Also, because the IRA owner died before the SECURE Act, by naming his partner, son and grandson as the beneficiaries of the IRA, they could have stretched the IRA over their life expectancies rather than over the IRA owner’s remaining life expectancy as if he hadn’t died.
Finally, in the most recent ruling, PLR 202140011 (released July 12, 2021), the IRS again permitted post mortem reallocation of the IRA benefits in an inherited IRA. Decedent B had named a sibling Decedent A as beneficiary of the IRA. In this case, the Decedent A had named a trust as beneficiary of the IRA and passed after the RBD. The trust was for the benefit of the three children of the Decedent A. The IRS allowed the IRA to be transferred in a “trustee to trustee” transfer into individual IRAs titled “IRA of Decedent B fbo (name of child), as beneficiary Decedent A.” This ruling permitted the interests of the three children to be separated.
The good news is the IRS is receptive to legal arguments that under the right facts, an IRA may be redirected directly to the heirs of a decedent. However, the New Jersey Courts generally need to be involved since the IRA administrator will usually request a court order confirming that the redirection of the IRA has been approved by all interested parties.
The best planning tool is to make sure the primary and contingent beneficiaries are named on all retirement asset designation forms.