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A surviving spouse has several options to consider when inheriting an IRA, but, for many, the most favorable may be a type of rollover transaction that provides valuable tax deferral benefits. However, for this option to be available, the rules governing beneficiary designations must be followed precisely—and many clients often err in believing that anytype of trust that benefits the spouse may be used to transfer the IRA without loss of the spouse’s rollover option.
Despite this, a little known exception has been developed through IRS rulings that can allow a surviving spouse to reap the tax benefits of the inherited IRA despite some of the simple and common errors that could otherwise cause the option to be lost entirely.
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Spousal Rollovers: The Options
Typically, a surviving spouse has several options available when he or she inherits a deceased spouse’s IRA. The surviving spouse can begin to take distributions immediately, using his or her own life expectancy to control the required minimum distributions (RMDs). He or she may also begin taking distributions once the deceased spouse would have reached age 70 ½ (the age when the deceased spouse’s RMDs would have began).
The most attractive option for many surviving spouses, however, is to simply roll the inherited IRA funds into an IRA that is treated as though it were the surviving spouse’s own IRA. If the surviving spouse is named as the sole beneficiary of the IRA and elects to treat the inherited IRA funds as though they were his or her own, the account will be treated as though the surviving spouse is the owner for all purposes—including RMD calculations.
Despite the appearance of simplicity that the rollover option generates, in many cases the deceased spouse’s beneficiary designation can operate to create potential roadblocks for the strategy—which is where the exceptions to the rule become important.
Saving the Spousal Rollover
One common error in beneficiary designation occurs when an IRA owner names a trust as his or her IRA beneficiary without properly structuring that trust as a see-through trust (which is essentially an irrevocable trust with clearly identifiable individuals who are the trust beneficiaries). Generally, the IRA owner’s mistake occurs in naming a revocable trust as beneficiary.
Several recent IRS rulings, however, have indicated the development of an exception to the rule in the case of revocable trusts where the surviving spouse has complete control and discretion over the account proceeds once they are transferred into the trust. In these cases, upon the IRA owners’ deaths, the IRA funds were distributed to the trusts. The surviving spouses then attempted to roll those funds into their own IRAs, a technique that, as discussed above, would have been easily accomplished without tax liability had the surviving spouses themselves been designated IRA beneficiaries.
The general rule governing inherited IRA funds that are paid into a trust provides that the surviving spouse is no longer eligible to roll those funds into an IRA in his or her own name once they are actually distributed to that trust. In such a case, the surviving spouse is treated as though he or she received the proceeds from the trust, rather than from the deceased spouse’s IRA.
However, the IRS has found that this general rule does not apply when the funds are treated as distributed to the surviving spouse only because he or she is named as sole trustee of the trust that received the IRA proceeds. In each of these rulings, the surviving spouse was sole trustee and had the power to control trust payments, add trust property, or amend or revoke the trust. Therefore, the IRS exempted them from the general rule and allowed them to roll the IRA proceeds from the trust into their own IRAs within sixty days without incurring income tax liability.
Many clients who inherit an IRA from a deceased spouse can benefit from rolling those funds into their own IRAs—understanding the exceptions to the general rule can help these clients simplify their estate planning while taking advantage of valuable tax breaks despite the naming of an ineligible trust as IRA beneficiary.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.