Spousal Rollovers for Younger Surviving Spouses May Be Hazardous to your Health

A recent tax court case determined that Wachovia Bank incorrectly distributed IRA proceeds from a deceased’s estate by rolling it over into the spouses IRA. The Court determined it had no jurisdiction to unwind the rollover, which was made in error by Wachovia stating, once it is rolled over the distributions become taxable.

Thomas Ozimkoski Sr. died at the age of 62 leaving his entire estate to his wife, Suzanne Ozimkoski. As part of his estate, he had an IRA at Wachovia with a value of approximately $235,000. He had not named a beneficiary for his IRA prior to his death. Suzanne was 51 years old at the time of Thomas’ death. Thomas also had a son from a previous marriage who contested the Will. Due to the contesting of the Will, Wachovia froze the IRA asset distribution, pending resolution.

A settlement was reached in which Suzanne agreed to pay Thomas’ son $110,000 free of taxes. In July of 2008 Suzanne transferred $235,495 from her husband’s IRA into her own IRA. This amount represented almost all of Thomas’ IRA. Suzanne then took $141,997 and distributed it from her IRA to herself. The following day, Suzanne wrote a check to Thomas’ son for $110,000 for the agreed settlement.

Suzanne then took additional distributions from her IRA in 2008, so that the total 2008 distribution was the equivalent of $174,597. Wachovia issued a 1099-R to Suzanne reporting the IRA distribution. In addition, the form 1099-R showed the distribution was an early distribution, subject to 10% penalty, since Suzanne was under age 59 ½.

Suzanne failed to report any of the IRA distributions on her 2008 tax return, The IRS applied a 10% penalty for early distribution and a late filing penalty, as well as accuracy related penalties.

In tax Court, Suzanne argued she was entitled to the $110,000 under the settlement agreement. The tax Court explained that Wachovia was only able to freeze the IRA if the estate was the named beneficiary, but there was no beneficiary designation on file.

The tax Court stated that Wachovia should have distributed the IRA to Thomas’ estate and that they had incorrectly rolled it over into Suzanne’s IRA, but there was no jurisdiction to unwind the rollover. In addition, the Court also sustained the late filing penalty and accuracy related penalty on the distributions in excess of $110,000, but did not impose the penalty with respect to the tax on the $110,000 of distributions as the Court felt she had reasonable cause and acted in good faith.

Typically, a surviving spouse can avoid the 10% penalty tax by remaining as a beneficiary of the deceased’s IRA as opposed to rolling the benefits over into the surviving spouses own IRA. The spouse, beneficiary, would not need to take distributions until the deceased spouse would have reached the required beginning date had the deceased spouse not died. Additionally, if the surviving spouse remained as a beneficiary dying before the deceased spouse would have reached the required beginning date, the surviving spouse’s beneficiaries would then be able to take distributions based on their own life expectancy, as though the surviving spouse had rolled the benefits over into their own IRA.

Lessons to be learned:

Suzanne should have considered the tax consequences when negotiating her settlement payment coming from her IRA. If she had realized the tax hit she would take, she may have been able to offer a smaller amount.

She also may have been able to utilize other estate assets as part of the distribution equaling the $110,000, thus reducing her tax hit.

Spousal beneficiaries of retirement benefits are best counseled to consider whether rolling the benefits over into their own IRA is warranted, as opposed to remaining beneficiary of the deceased’s IRA.