Taxation & Estate Planning

LATE CONVERSION TO LIFETIME PAYOUT FROM INHERITED IRA ALLOWED

By Charles Rubin

When an IRA owner dies before the required beginning date of required IRA distributions, a nonspouse beneficiary of the IRA can either take the IRA out over the beneficiary's remaining life expectancy, or take the entire IRA out within 5 years of the IRA owner's death (by December 31st of the 5th year after such death). Since IRA distributions are generally taxable to the recipient, taking the IRA out over the beneficiary's life expectancy typically results in two benefits. First, the payouts will be spread over many years, continuing the tax deferral aspects of the IRA and deferring taxes to the recipient. Second, it avoids bunching of the payouts which could result in even higher income taxes by pushing the recipient into a higher income tax bracket.

To avoid the 5 year payout rule and use the life expectancy rule, life expectancy distributions to the beneficiary must begin on or before the end of the calendar year immediately following the calendar year in which the employee died. Therefore, beneficiaries need to act in a timely manner to secure this tax benefit.

In a recent private letter ruling, the IRS did allow a beneficiary to use the life expectancy rule, even though the first distribution was not made within the above time limit. In the ruling, the beneficiary made up the missed annual distributions in later years, but prior to the expiration of the 5 year period.

The IRS' generosity was not unlimited, however. The beneficiary had to pay the usual penalty on late IRA distributions for the late payments - 50% of the required distribution. The taxpayer may also have incurred higher taxes than would have been the case if the payments had been made timely, since the bunching of makeup payments and the required payment in one tax year may have pushed the taxpayer into a higher bracket for the years of the makeup payments. The taxpayer is also out the fees for applying for the ruling, including professional fees which were likely incurred.

Since this relief was granted in a private letter ruling, it is not automatically available to everyone in the same situation. Instead, similarly situated taxpayers will have to apply for a ruling to get the relief. Per the language of the ruling, if the IRA documentation provides that a 5 year payout is the default payout method, then a ruling may not be available in those circumstances.

PLR 200811028

Full post as published by Rubin on Tax on March 22, 2008 (boomark / email).