Professionals often advise individuals to name their spouse as a beneficiary of an IRA. Instead of immediately reporting the distributions from the deceased spouse’s IRA as taxable income, the surviving spouse can rollover the amount into their own IRA. They can then defer distributions (and thus income) until they reach age 70 1/2. This special rule allows the IRA to grow income tax free until the time distributions are received. However, this is not always the best alternative, as was shown in the case of Suzanne C. Oster Ozimkoski.
During the probate of Tom’s estate, Tom Jr., Tom’s son from a prior marriage, challenged Tom’s Last Will and Testament. Wachovia, the custodian of the IRA, froze the IRA account. Suzanne and Tom, Jr. ultimately entered into a settlement agreement. Suzanne agreed to pay Tom, Jr. $110,000 and give him a motorcycle.
After the settlement agreement was signed, Wachovia transferred Tom’s IRA into Suzanne’s IRA even though there was NO beneficiary designation. Suzanne then took a $141,997.43 distribution from her IRA which she deposited in her personal checking account. She then wrote a personal check to Tom, Jr. for $110,000.
Wachovia issued Suzanne a 1099-Rshowing the IRA distributions as income. The Internal Revenue Code imposes a 10% penalty for distributions made from an IRA to individuals under age 59 1/2. An exception provides that the penalty would not apply if Suzanne had been named as a beneficiary and had taken distributions directly from Tom’s IRA. Suzanne reported neither income nor penalties on the IRA distributions on her income tax return and she filed her income tax return late.
The Internal Revenue Service (“IRS”) determined that Suzanne owed income taxes, together with the 10% penalty, a late filing penalty and an accuracy related penalty. Suzanne argued that the $110,000 distribution should not be taxed because she had to pay that amount pursuant to the settlement agreement. She also argued that the 10% penalty should not be imposed because the distributions came from Tom’s IRA and she was the surviving spouse.
The Tax Court agreed with the IRS as to the 10% penalty. Wachovia improperly “rolled over” Tom’s IRA into Suzanne’s IRA. The exception to the 10% penalty did not apply because Suzanne was receiving distributions from HER IRA, not Tom’s IRA. The court also imposed the late filing penalty. The accuracy related penalty was imposed only on the amount in excess of the $110,000 because Suzanne had reasonable cause to believe that she could make the settlement payment from the IRA distributions.
This was a terrible result for Suzanne and had she been represented by competent counsel she may have avoided all of this heartache. The really sad part is that the only other income for Suzanne was wage income from the Boys and Girls Club of Volusia County of less than$15,000. Total taxes and penalties from this IRA mistake were approximately $60,000!
The court noted that it was clear from the record that “petitioner’s attorney failed to counsel her on the full tax ramifications of paying” Tom, Jr. the $110,000 from her own IRA. The court also noted that “Wachovia incorrectly rolled over the entirety of ” Tom’s IRA to Suzanne’s IRA and noted that the court had “no jurisdiction to unwind that transaction and must decide” Suzanne’s tax liability on the basis of the erroneous transfer and the distribution from her IRA.
ADVICE: Anytime there is a retirement plan in a decedent’s name, you should obtain the beneficiary designation as soon as possible and discuss with a qualified attorney the alternatives and the tax consequences. Any time the surviving spouse is under age 59 1/2, then be sure to discuss whether the surviving spouse will need this money BEFORE rolling over the amount to the surviving spouse’s IRA. Further, ALWAYS hire a tax professional to review the tax consequences of any settlement agreement BEFORE you sign the dotted line!
WORD OF THE WEEK: Reformation is a remedy utilized by the courts to correct a written instrument so that it conforms to the original intent of the parties, usually to correct a fraud or a mistake, such as a mistake in the deed.
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