There's a lot of good news from the frontlines of individual retirement accounts (IRAs). There was a parade of private letter rulings, many quite beneficial to taxpayers. Some rule changes also made life easier.

Alarming

First, though, one sour note: It may be wise to shop for a new custodian for your IRA — one whom you can trust to pay your IRA upon your death to the beneficiary you named on your IRA beneficiary form. Not every custodian will. A Vanguard beneficiary form warns: “If you have one or more existing IRAs and choose to complete this [beneficiary form], we will apply the new designation(s) to all your existing Vanguard IRAs of the same type.” As first reported in a recent Forbes magazine article, the result can be that your custodian may disinherit some of your heirs.1

How's that possible? Let's say that three IRAs had different beneficiaries whom we'll call Larry, Moe and Dylan. The IRA owner made this arrangement to assure favorable treatment for purposes of required minimum distributions (RMDs) after he died, without requiring the beneficiaries to create their own IRAs by December 31 of the year after his death.

Let's also say that a company with a Vanguard-like policy processed the IRA naming Moe after it processed the other two IRAs. The company will treat Moe as beneficiary of ALL THREE IRAs. Larry and Dylan will be disinherited, not by falling out of favor with their dear parent, but by the IRA custodian's internal policy.

Confirming this result, Amy Chain, in Vanguard's public relations department, noted: “Vanguard&s new beneficiary policy will allow clients to have one set of beneficiaries for each type of IRA they hold with Vanguard. For example, if a client holds a traditional IRA and a Roth IRA, the client is permitted to have one set of beneficiaries on their traditional IRA, and then a completely different beneficiary set for their Roth IRA, if that's what they want.”

So it's possible to have each child get a specified percentage of all IRAs of the same type just by saying so on a new beneficiary form. You just can't have several IRAs of the same type with different beneficiaries.

As yet, there has been no legal challenge to such policies.

One cumbersome way to avoid inadvertently disinheriting beneficiaries and to assure the best stretch out would be to use separate custodians for each separate IRA, naming a unique beneficiary to each.

Or, you could just go shopping for an IRA custodian who promises not to implement such a policy.

Inherited IRAs

The Internal Revenue Service was looking for a sign from Congress about how badly the lawmakers want all retirement plans to offer the new, nifty “Inherited IRA” direct rollovers under IRC Sections 401, 403(b) or 457. Are plans required to do it or is it just an option for them?

The Pension Protection Act of 2006 (PPA)2 permitted, but did not expressly require, a direct rollover to an inherited IRA, from which a beneficiary could enjoy a lifetime of distributions. Just think of the long stretch out that a plan participant's grandchild-beneficiary might enjoy.

Such stretch outs were permissible before the PPA even without an IRA rollover, but many plans refused to allow them, instead forcing beneficiaries to take lump-sum distributions that are taxable immediately. Pre-PPA, only the surviving spouse could effect an IRA rollover.

The IRS at first said that, despite the PPA, nothing much should change: In Notice 2007-7, the Service claimed plans were not required to offer inherited IRA direct rollovers.3

Then two bills introduced in Congress during 2007 would have made offering the rollovers mandatory. Citing these bills, the IRS added the rollovers to its cumulative list of required plan amendments in an August newsletter.4

But wait! The IRS did another turnaround. When the Service issued its cumulative list in Notice 2007-94, it must have decided not to anticipate the law change. The entry for the rollover says such rollovers are allowable — but there's no mention of a required plan amendment. Instead, the reader is directed back to Notice 2007-7, meaning plans can but are not forced to offer them.

As we go to press, Congress is not considering either of the bills mentioned in the IRS' August newsletter.5 Both were rolled into the Tax Technical Corrections Bill of 2007.6 And notably missing from that bill is any mandate for plans to offer the rollovers.

In other words, this holiday present from Congress was dead on arrival, and the IRS isn't likely to revive it. So while plans still can offer the rollovers, they don't have to. To avoid administrative hassles, chances are that many won't.

But there is hope that some plans will. And a qualified plan amendment offering non-spouse beneficiaries the right to roll over death benefits to an inherited IRA surfaced in PLRs 200717022 and 20071703, the first ever issued under the PPA rollover provision.

In those PLRs, an unmarried participant in an Internal Revenue Code Section 401(a) qualified plan died after submitting all forms needed for transferring his plan account to his pre-existing IRA, but before his plan account could complete the transfer. The plan administrator stopped all action on the account. His plan beneficiary, who also was his IRA beneficiary, was the sole personal representative of the decedent's estate.

The IRA was re-titled as an IRA of the decedent, held for the benefit of its named beneficiary (an inherited IRA).

The plan needed to be amended to permit inherited IRA direct rollovers. Although not adopted at the time of the participant's death, there was such an amendment in place by the time the transfer was made to the inherited IRA.

The decedent also had died before reaching his required beginning date (RBD). That meant one of two RMD rules could apply: Either all benefits might have to be paid within five years of his death, or, alternatively, all benefits might be payable over the beneficiary's life expectancy.

The IRS ruled that, once the plan amendment was adopted, transfer to the IRA would constitute a permissible direct rollover to an inherited IRA, and the RMDs could be made over the beneficiary's life expectancy.

Trade-in

New rules also benefited taxpayers by streamlining a process. Query: What could be better than trading in a taxdeferred non-IRA account for a new tax-free Roth IRA? Answer: making this trade in one step rather than two.

Out with the old: Under the previous rule for converting a qualified plan account to a Roth IRA, a twostep process was required. Say that Allen had a 401(k) account with his former employer. Allen was retired and wanted to convert his account to a Roth IRA during a tax year when he'd satisfied all requirements for a Roth IRA conversion. Before the conversion could be made, Allen first would have to transfer or roll over his 401(k) account to a traditional IRA. Only then could he convert the traditional IRA to a Roth IRA.

In with the new: 2008 is the first year during which Roth IRA conversions of eligible retirement plans other than IRAs need not take the intermediate step of first being transferred to an IRA.7 Among the retirement plans that fall within the definition of “eligible retirement plans” are qualified retirement plans maintained by employers. These include qualified retirement accounts, Section 403(b) contracts and Section 457 accounts.

Beginning in 2008, Allen may convert his 401(k) account directly to a Roth IRA. There's no need to first transfer or roll it over to a traditional IRA.

Surviving Spouses

The IRS seems to have a soft spot for surviving spouses. Surviving spouses have long enjoyed preferential treatment in retirement plan death benefits. First among those privileges is the ability to roll over retirement plan benefits to an IRA held in the name of, and treated as an IRA of, the surviving spouse. But the surviving spouse must be the beneficiary of the retirement plan benefits before the spousal rollover can occur. Naming a trust or an estate instead of a surviving spouse could spoil the rollover privilege. Nevertheless, a long line of rulings says: never say “never.”

In 2007, we saw a continuation of a years-long run of PLRs permitting IRA rollovers by surviving spouses, even though a trust or estate was named as the beneficiary. All of the 2007 rulings and most of the PLRs issued after promulgation of the final IRS regulations detailing when a surviving spouse can make a rollover cite the preamble to those regulations and say that a surviving spouse who actually receives a distribution from an IRA is permitted to roll that distribution over into his/her own IRA, even if the spouse is not the sole beneficiary of the deceased's IRA. The surviving spouse can do this as long as the rollover is accomplished within the requisite 60-day period; a rollover may be accomplished, even if IRA assets pass through either a trust or an estate.8

Court reformations granting the surviving spouse access to retirement benefits played a pivotal roll in several spousal IRA rollover rulings.

In one, PLR 200704033, the IRS said a spousal rollover was allowable because a reformation of the trust effective as of the decedent's date of death granted the surviving spouse the right to withdraw IRA proceeds paid to trust. But the rollover couldn't be made within the 60-day rollover period, because the IRA custodian, mistakenly moved the IRA investments into a non-IRA account. The IRS waived the 60-day rollover.

The trust was modified to allocate, to the extent possible, retirement benefits to a trust over which the surviving spouse had a power to withdraw. Better yet, the modification provided: “Notwithstanding any other provision of this Agreement, to the extent that any Retirement Benefits are allocated to Subtrust U, the Trustees may (and shall, if requested to do so by Settlor's wife (Taxpayer B)) cause such Retirement Benefits to be paid directly to the Settlor's wife as beneficiary, or to another individual retirement account or retirement plan account in the Settlor's wife's name and may do so without the intervening step of payment to the Trustees.”

The reformation was key to this ruling. It gave the surviving spouse the right to the IRA, without depending on any exercise of trustee discretion to allocate it to her.

Similarly, in PLR 200703047, a trust was beneficiary of two IRAs. A court reformed the trust to pass the IRA death benefits to the surviving spouse of the decedent, free of trust. The IRS respected the reformation and said the spouse could roll over the IRA distributions. But before she could, the independent co-trustees, in an ill-fated effort to consolidate the IRAs into a single IRA mistakenly transferred the IRA distributions to a non-IRA account. The surviving spouse was unaware of the botched transfer. Although the spouse received the funds from the trustees, their missteps prevented her from meeting the 60-day rollover deadline. The IRS waived the 60-day rollover requirement for the spouse.

PLR 200703035 continues the theme of a circuitous path leading ultimately and inexorably to the surviving spouse. In this case, the estate was named IRA beneficiary. The decedent died testate. Under the decedent's will, the surviving spouse was named and appointed executrix, and had the unfettered power to direct the IRA to herself. An employee told her the spousal rollover would be a two-step process in which the decedent's IRA would be transferred first to a non-IRA account. Then, within 60 days of the IRA distribution, there would be another transfer, this time to an IRA. The employee was wrong about the timing, and the IRS granted a waiver of the 60-day rollover deadline.

A new twist on the spousal rollover theme appeared in PLR 200705032. In that case, a trust was named beneficiary of four IRAs. The IRS held that the surviving spouse could make a rollover, despite the presence of independent trustees. The trust granted a trustee power to allocate the IRA among subtrusts. The trustees allocated the decedent's IRA to a subtrust over which the surviving spouse held a lifetime power of withdrawal. The IRS regarded as sufficiently strong the connection between the IRA and the surviving spouse to allow the rollover, saying: “The Cotrustees satisfied their obligations under the law of State I by allocating life insurance proceeds to the Family Trust, and IRAs W, X, Y, and Z to the Marital Trust.” The family trust would escape estate taxes on the death of the surviving spouse, while the marital trust would not.

The Service also found a spousal rollover could occur when the retirement plan beneficiary was the surviving spouse, but the plan account was paid to the decedent's estate by mistake. Those were the facts and the holding in PLR 200722031.

An updated beneficiary form properly lodged during a retirement plan participant's lifetime changed the beneficiary of a retirement plan account. The beneficiary had been the participant's estate. It was changed to the participant's spouse. When the participant died, the plan administrator acknowledged in writing that the surviving spouse was the beneficiary. But when it came time to distribute in a single lump sum the balance standing in the decedent's account, the check was made out to the decedent's estate by mistake.

The surviving spouse recognized the mistake and returned the check. The plan administrator also saw the mistake, not only crediting the account for the returned check, but also crediting the account with income and gains that would have been earned while the account balance had been zero.

Before taking any further steps, rulings were sought approving the plan administrator's actions, and confirming the right of the surviving spouse to roll over the distribution within 60 days of her receipt of the proposed “new” distribution, ignoring the date when the mistaken check was received. The IRS ruled favorably on both questions.

Another reformation underpinned PLR 200707159. Two IRAs and a qualified plan account were payable to a trust when the participant died. The surviving spouse was trustee of the trust. As trustee, she could and did allocate the retirement accounts to a subtrust from which she could withdraw principal and income.

After receiving bank forms for setting up an IRA for the trust and after extensive consultation with professional advisors and bank personnel, the forms were filled out and submitted. The bank then turned the case over to “an attorney inexperienced in estate planning which involves qualified arrangements and spousal rights with respect thereto.”

All funds wound up in a non-IRA account. The spouse discovered this after the 60-day rollover limit expired, when Forms 1099R reporting taxable distributions were received. By this time, the surviving spouse had spent some of the money.

The IRS held that the spouse could roll over what the surviving spouse had not yet spent, and granted a waiver of the 60-rollover deadline.

Rollover, Interrupted

As demonstrated in the surviving spouse rulings, the IRS has authority to grant a waiver of the 60-day IRA rollover deadline. A waiver was granted in PLR 200719018 because an intended rollover was prevented by death. The surviving spouse had been named beneficiary of the IRA annuity the decedent had withdrawn. She sought to roll over the amount involved into her own IRA. This the IRS allowed.

No waiver was needed in PLR 200717021 when a surviving spouse, acting as administratrix of her late husband's estate, opened an IRA in his name and completed his rollover for him within the 60-day deadline. The ruling held that a valid rollover contribution was made. But any beneficiary designation placed on the new account would not be valid for RMD purposes and, according to the IRS, there was no remedy for that. Therefore, the RMD rules applied as “to an individual who died after having attained his required beginning date without having designated a beneficiary thereof.”

More Reforms

Court-approved reformations figured into non-spouse IRA beneficiary designations as well.

PLR 200707158 reveals a family feud. The IRS respected a settlement agreement and a related court order reforming the IRA beneficiary designation, thereby changing the identity of the beneficiary. Transfer to an inherited IRA for the benefit of that beneficiary was allowed. The IRS disowned the question of how to apply RMD rules.

The decedent (let's call him Alan) had two cousins, whom we'll call Brad and Chester. Brad had acted as attorney-in-fact for Alan. But it was Chester who served as executor of Alan's estate. An IRA worth about half of the value of the estate had been left to Brad's three children. Shortly after the decedent's death, the IRA was transferred to three IRAs. Brad's three children withdrew RMDs annually.

Also after Alan's death, Chester brought a court action accusing Brad, among other things, of undue influence in arranging the IRA beneficiary designation. Brad and Chester hired counsel. The parties conducted extensive discovery, and the court set a trial date. A settlement was reached before trial. The court accepted the settlement. It issued a judgment reforming the IRA beneficiary designation, effective the day before the date of death. The reformed beneficiary designation named Chester as beneficiary. But Brad's children were not required to return the IRA distributions they had already received.

Next, a brand new IRA was set up in Alan's name for the benefit of Chester as beneficiary. The three IRAs held for the benefit of each of Brad's children were transferred to the new IRA.

One of Brad's children requested the PLR, asking whether he had made a taxable gift by entering into the settlement agreement and if the transfer of his inherited IRA to the new one for Chester would result in any taxable IRA distribution to him. A ruling was also sought that future distributions from the new IRA will not be taxable to him.

The Service ruled favorably on all three questions. To reach its rulings, the IRS relied on Ahmanson Foundation v. United States (limiting charitable and marital estate tax deductions based on settlement of adverse proceedings to enforceable rights under state law), citing Commissioner v. Estate of Bosch (stating, for purposes of applying federal tax law, only the highest state court opinion will avoid a federal determination of how the highest state court would rule.)9

The unanswered question about how to apply RMD rules is tantalizing. Because the reformed beneficiary designation relates back to the day before death, it could be argued that Chester was the designated beneficiary for RMD purposes.

The beneficiary under RMD regulations must be a beneficiary as of the date of death and as of September 30 of the following year.10 Under the reformed beneficiary designation, is that person Chester? Does the reformation retroactively change what RMD amounts should have been distributed up to the date of reformation? If federal tax law determinations must follow the reformation, it might well be that the answer to both questions is yes.

Let's assume Chester was older than Brad's children. The ruling tells us that for one or more years, the RMD was paid out of the three inherited IRAs based on the life expectancies of Brad's children. The ruling does not say whether the decedent died before reaching his RBD. We therefore can only speculate about whether the five-year rule and the life expectancy rule might have applied. The worst that could have happened was that, somehow, it did.

Of course, the IRS does not always accept a court reformation. The reformation parade took an unwelcome detour in PLR 200742026, a sobering reminder that PLRs cannot be relied on by anyone other than the taxpayer to whom they are issued. The IRS found a court reformation of a beneficiary form (to comply with the intent of a decedent) was not effective to stretch RMDs over the life of the decedent's daughter. The daughter argued successfully before the local court that she should have been named contingent beneficiary. Her mother, who was primary beneficiary, had predeceased her father. The daughter had been named contingent beneficiary on a previous IRA as well as in her father's will. An employee of the IRA custodian for the decedent's IRA had called this inconsistency to the attention of the father, who never responded.

Restoring Damages

More often than not, though, the IRS showed mercy. Investment detours caused by less-than-ethical investment professionals left several unfortunate victims. The IRS granted them all restoration of damages awards in PLRs 200705031, 200714030, 200719017, 200738025 and 200724040.

The theme common to all of these rulings is application of Revenue Ruling 2002-45 to IRAs.11 While the revenue ruling applies to qualified plans by it terms, the IRS applied it to IRAs in these PLRs. The IRS distinguishes between a restorative payment and a plan contribution. According to all five rulings, restorative payments occur when made to restore “some or all of the IRA losses resulting from breach of fiduciary duty, fraud or federal or state securities violations (such as payments made pursuant to a court-approved settlement or independent third party arbitration or mediation award.)” Such payments are distinguishable from “payments made to an IRA to make up for losses due to market fluctuations or poor investment returns” and are contributions rather then restorative payments.

PLR 200705031 is notable for the case's absence of legal representation, court action or arbitration. After the IRA owner died, the surviving spouse received a settlement of her deceased husband's claim, which she accepted under the terms of a settlement agreement.

The husband had started a letter writing campaign, which continued after his death by his surviving spouse and their daughter. The IRS found that the amount approximated, but did not exceed the investment losses suffered in the decedent's IRA.

The other PLRs involved proceeds from arbitration proceedings or settlements arising in that context.

IRAs and Charities

Investing can be a risky business, even with the best of investment advisors. Seeking to stabilize investment returns, some IRA owners choose to invest some portion of their holdings in bonds or, as in PLR 200741016, to make direct loans. A self-directed IRA made a loan to a charity. That charity used the loan proceeds to buy life insurance on the IRA owner and may have had enough left over to pay the interest on the loan. The loan was repayable at the earlier of 20 years or the insured IRA owner's death.

This arrangement is groundbreaking in that it offers the possibility of creating a significant testamentary benefit to charity through an IRA-financed life insurance deal. But the transaction has many moving parts, making it susceptible to error.

At the same time, the retention by the IRA of a promissory note earning interest will leave non-charitable beneficiaries of the IRA owner's estate in a substantially similar, if not the same, economic position compared with doing nothing for the charity.

So this arrangement could suit someone who wishes to benefit charity upon his death through life insurance, for those who are insurable and intend to invest some part of an IRA in interest-bearing securities. Of course, the charity must have an insurable interest in the insured. The taxpayer's representative said that condition was met — but the IRS did not pass on that issue.

Charitable IRA Transfers

And speaking of charities: IRA owners and beneficiaries over age 70½ shopping for good (tax-efficient) karma will miss charitable IRA transfers ushered in by the PPA.12 The PPA charitable IRA transfer expired Dec. 31, 2007. But, at press time, legislation is proposed to extend or even expand this opportunity so that individuals could transfer taxdeferred retirement savings to a qualifying charity without recognizing a taxable IRA distribution.

Many people, myself included, hope that Congress will enable this worthy act of goodwill towards America's charities.

Endnotes

  1. Ashlea Eberling, “Disinherited by Vanguard,” Forbes, Sept. 3, 2007 at p. 68.
  2. Pension Protection Act of 2006 (PPA), P.L. 109-280, Aug. 17, 2006, Section 829.
  3. Notice 2007-7, 2007-5 I.R.B. 395, Q&A 14.
  4. The item in the newsletter cited: “section 9(e) of S. 1974, the Pension Protection Technical Corrections Act of 2007, as introduced in the Senate on August 2, 2007 and section 9(e) of H.R. 3361, the Pension Protection Technical Corrections Act of 2007, as introduced in the House of Representatives on August 3, 2007.”
  5. 2007-51 I.R.B. 1179, at VI(10).
  6. S. 2374, H.R. 4195.
  7. PPA Section 824.
  8. Treasury Decision 8987, 67 F.R. 18988-19028, April 17, 2002, at p. 54.
  9. Ahmanson Foundation v. United States, 674 F.2d 761, 774-75 (9th Cir. 1981); Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).
  10. Treasury Regulations Section 1.401(a)(9)-4, Q&A-4.
  11. Revenue Ruling 2002-45, 2002-2 C.B. 116.
  12. PPA Section 1201.

Michael J. Jones is a partner at Thompson Jones LLP of Monterey, Calif. He is also the chair of the Trusts & Estates retirement benefits committee