Saving A Stretch: A New IRS Ruling Sheds New Light On Stretching Inherited IRAs, Even When The Client Misses Distributions

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July 1, 2008

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Saving A Stretch: A New IRS Ruling Sheds New Light On Stretching Inherited IRAs, Even When The Client Misses Distributions

Ed Slot

In a recent private letterruling (PLR 200811028), the IRS allowed an IRA beneficiary to take distributions over her lifetime, even though she neglected to take the first two years' required minimum distributions (RMDs) from the inherited IRA.

The IRA owner died in 2002 at age 66, before his required beginning date (RBD) for withdrawals. He had named his daughter the sole beneficiary on his two IRAs. In 2003, when RMDs would have had to begin, she would have been 31. 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. Since the owner died before his RBD, no distributions were required before his death in 2002.

But the RMDs would have had to begin in 2003. The daughter did not take RMDs for 2003 and 2004, but in 2005 she took RMDs for all three years (2003, 2004 and 2005) to make up the missed RMDs. She did not elect the five-year distribution rule and took the RMDs according to her life expectancy. In 2007, she paid the 50% penalty for the missed 2003 and 2004 RMDs.

Better Late Than Never?

In the private letter ruling, the IRS stated that "the issue to be addressed is whether the failure to timely take certain required distributions requires that distributions from either IRA X or IRA Y (or both) be made in accordance with the five-year rule of Code section 401(a)(9)(B)(ii)."

IRS ruled that the answer was no. Missing RMDs does not cause the beneficiary to default to the five-year rule. The daughter still gets the stretch IRA. What's more, the custodial agreements on both IRAs stated that they were to be paid out according to the life expectancy method.

Under the five-year rule, the inherited IRA must be completely withdrawn by the end of the fifth year following the year of death. For example, if the IRA owner died in 2008, the beneficiary would have to withdraw the entire account by the end of 2013. There are no distributions required in any specific year, as long as the deadline is met.

Since Final Regulations were issued in 2002, the five-year rule should rarely apply. Before then, missing RMDs from an inherited IRA could force a beneficiary into the five-year rule.

When Penalties Apply

Required distributions from most retirement plans must begin after age 701/2. Any portion of the missed required distribution is subject to a penalty of 50%. Unknown to many IRA and plan beneficiaries, the 50% penalty also applies to them. It applies to RMDs from inherited traditional IRAs as well as inherited Roth IRAs. Even though Roth IRA owners are not subject to RMDs, children or other non-spouse beneficiaries who inherit a Roth IRA are subject to RMDs, just as if they inherited a traditional IRA. The only difference is that, in general, the RMDs to the Roth IRA beneficiary will be tax- free-but they are still subject to the 50% penalty if they are not taken.

The 50% is certainly a harsh penalty, though the good news is that most people don't pay it. The IRS has been extremely liberal in waiving the penalty for good cause, so long as the missed RMDs are made up and steps are taken to prevent any shortfall in future years.

New, Easier Stretches

Under the current distribution rules, the stretch IRA is the default. It does not have to be elected anymore, as it did under the old rules. Every designated beneficiary gets the stretch IRA, as long as the IRA custodial document does not default to the five-year rule. Unbelievable as it may seem, there are still companies that force beneficiaries to empty inherited accounts.

Under the tax rules, since the daughter was the designated beneficiary, she automatically qualifies for the stretch IRA. So why did she go through the time and expense of requesting a private letter ruling?

We don't have the inside facts of the ruling at this time, but it appears that the penalty was paid to avoid defaulting to the five-year rule. The daughter may have been worried that because she missed the first two years of RMDs, she would default to the five-year rule-or she may have been told that by the financial institution. She may have wanted, or needed, an official ruling from the IRS stating that her failure to take RMDs did not cause her to default to the five-year rule. If the rule applied, she would have had to withdraw the entire balance by the end of 2007.

The amount of the inherited IRA was probably substantial; otherwise the cost of the ruling would not have been worth the benefit. With a large IRA, the difference between taking distributions under the five-year rule and over a life expectancy of 52.4 years would be exponential. The fact that the daughter was so young and wanted to guarantee the extended payout may have been a key factor in getting the IRS to bless this with a ruling.

In this PLR, the IRS made it clear for the first time that, as the Final Regulations state, the stretch method is the default and the five-year rule does not apply.

The IRS also pointed out that the IRA custodial agreement for each of the inherited IRAs required the life expectancy payout (the stretch). If the IRA custodial agreement said the five-year rule applied (even though the law clearly does not say that), would the beneficiary be stuck with the five-year rule? This is likely to be the case.

Since the tax regulations default to the stretch IRA for a designated beneficiary, most IRA custodial agreements do the same. But there is no guarantee. That is why advisors should check the IRA custodial agreements for all IRAs they manage. Some financial institutions restrict beneficiary options in their IRA custodial agreements or annuity contracts and might not allow the stretch IRA. Now is the time to check, while the client is still living. Check These Details

Advisors must make sure that when a beneficiary inherits, RMDs are taken in a timely manner to avoid the 50% penalty, and the cost and time involved in requesting rulings like this one.

Also check that beneficiaries are not withdrawing under the five-year rule, which should only apply to a non- designated beneficiary when the account owner dies before reaching his or her required beginning date.

As always, advisors should check all beneficiary forms to be sure that clients have named a beneficiary. Also, check all IRA custodial agreements to ensure they state that the life expectancy method is the default payout method for designated beneficiaries. This may have been a crucial factor in this ruling.

Although a PLR cannot be relied on (except by the taxpayer who requested it), this ruling provides a strong case that the stretch IRA is available to a designated beneficiary, even if RMDs on the inherited IRA are missed. Ed Slott, a CPA in Rockville Centre, N.Y., created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisors, financial advisor firms and insurance companies become leaders in the IRA marketplace. For more information, visit www.irahelp.com. (c) 2008 Financial Planning and SourceMedia, Inc. All Rights Reserved. http://www.Financial-Planning.com http://www.sourcemedia.com

July 1, 2008