Rolling Over An Inherited IRA

I am not a fan of the 60-day IRA rollover.

I admit that my response is colored by being the tax guy cleaning-up when something goes awry. Unless the administrator just refuses a trustee-to-trustee rollover, I am hard pressed to come up with a persuasive reason why someone should receive a check during a rollover.

Let’s go over a case. I want you to guess whether the rollover did or did not work.

Taxpayer’s mom died in 2008.

Mom had two IRAs. She left them to her daughter, who received two checks: one for $2,828 and a second for $35,358.

The daughter rolled over $35,358 and kept the smaller check.

On her tax return, she reported gross IRA distributions of $38,194 (there is a small difference; I do not know why) and taxable distributions of $2,828.

She did not have an early distribution penalty, as that penalty does not apply to inherited accounts.

The IRS flagged her, saying that the full $38,194 was taxable.

What do you think?

Let’s go over it.

There is no question she was well within the 60-day period.

The money went into an IRA account. This is not a case where monies erroneously went into something other than an IRA.

This was the daughter’s only rollover, so we are not triggering the rule where one can only roll IRA monies in this manner once every twelve months.

The Court decided that the daughter was taxable on the full amount.

Why?

She ran face-first into a sub-rule: one cannot rollover an inherited account, with the exception of a surviving spouse.

The daughter argued that she intended to roll and also substantially complied with the rollover rules.

Here is the Tax Court:

The Code’s lines are arbitrary. Congress has concluded that some lines of this kind are appropriate. The judiciary is not authorized to redraw the boundaries.”

This is a polite way of saying that tax rules sometimes make no sense. They just are. The Tax Court, not being a court of equity, cannot decide a case just because a result might be viewed as unfair.

The Court did not address the point, but there is one more issue at play here.

There are penalties for overfunding an IRA.

Say that you can put away $6,500. You instead put away $10,000. You have overfunded by $3,500.

So what?

You have to get the excess money out of there, that’s what.

Normally I recommend that the $3,500 be moved as a contribution to the following year, nixing the penalty issue.

Let’s say that you do not do that. In fact, you do not even know to do that.

For whatever reason, the IRS examines your return five years later. Say they catch the issue. You now owe a 6% penalty on the overfunding.

That’s not bad, you think. You will pay $210 and move on.

Nope.

It is 6% a year.

And you still have to get the $3,500 out.

Except it is now not $3,500. It is $3,500 plus any earnings thereon for five years.

Say that amount is $5,500, including earnings.

You take out $5,500.

You have five years of 6% penalties. You also have tax on $2,000 (that is, $5,500 minus $3,500).

If you are under 59 ½ you probably have an early-distribution penalty on the $2,000.

Plus penalties and interest on top of that.

I like to think that the Tax Court cut the taxpayer a break by not spotlighting the overfunding penalty issue.

Our case this time was Beech v Commissioner.