By Jeremy T. Rodriguez, JD
Legal training is less about memorization and more about understanding how to break down complex problems. With that mind, I often suggest that people understand the law and not try to memorize it. Why was it enacted and what is it trying to prevent, or encourage? Of course, there are exceptions to this general rule. In this arena, I’m talking about laws or rules that are easy to remember and which can lead to mistakes that cannot be undone. Those should be committed to memory.
One such rule is the IRA transfer rule for non-spouse beneficiaries; a non-spouse beneficiary cannot do a 60-day rollover. That means if IRA funds are distributed to a non-spouse beneficiary, it is a taxable distribution. This mistake cannot be undone.
This simple rule proved costly for a taxpayer in the important case of Beech et. ux. v. Commissioner. The taxpayer was an adult daughter who inherited her mother’s traditional IRA. The account held $38,186 and soon after the mother’s death, the IRA custodian issued the beneficiary two checks: one for $2,828 and another for $35,358. The taxpayer never alleged that the distribution was a mistake, so she either requested the distributions or otherwise approved them.
The taxpayer kept the smaller check and deposited the larger one into an inherited IRA she set up with another custodian. She made the deposit within 60 days after receiving the $35,358 check. Thinking she had rolled over the assets, she did not report the larger IRA distribution on her 2008 tax return. The IRS figured it out and issued a notice of deficiency for over $9,000. The dispute wound up in Tax Court where the taxpayer argued that she had misunderstood the rules, had otherwise complied with the 60-day rollover rules, and had always intended to roll over the larger check from the inherited IRA. In other words, she argued that she had substantially complied with all the relevant rules and asked to the IRS to give her a break. In rejecting her argument, the Tax Court ruled that intent was irrelevant. The only way a non-spouse beneficiary can transfer an inherited IRA is through a direct trustee-to-trustee transfer. Because the taxpayer did not do this, she was left with a taxable distribution. There was no way to fix her mistake.
As detrimental as the ruling was to the taxpayer, it could have been worse. Since that larger check (i.e., the one for $35,358) was not an eligible IRA contribution, it was technically an excess contribution under the Tax Code. That means it needed to be removed by October 15th of the year following the year it was contributed. If not, the IRS imposes a 6% penalty per year for every year that those assets remain in the account.
In this case, that means Mrs. Beech should’ve been assessed the penalty for every year the assets remained in the second inherited IRA. The court record doesn’t indicate how long the assets stayed in the second inherited IRA, but we know they were deposited in 2008 and the ruling was issued in 2012. It’s possible the IRS assessed these penalties after the Court decision. Ultimately, while I always suggest that people contact knowledgeable advisors before taking action, there are some mistakes which are too easy to avoid.