inherited ira problem and co-mingling of ira’s
client of mine inherited an ira from his mother four years ago. old advisor placed inherited money in traditional ira, not a beneficiary ira. no RMD’s have been taken. then, money from his old 401k was co-mingled into this same traditional ira. what options does my client have? can he seperate assets and put inherited money into a beneficary ira, then take out past RMD’s? what can he do with the least tax consequences? what about 5 year deferral option?
Permalink Submitted by Alan Spross on Mon, 2007-09-17 23:59
The old advisor has made a very basic and critical error that constitutes a taxable distribution of the inherited IRA. One might think that the taxpayer would have to amend his return for that year declaring the distribution in income, but the IRS has decided that this error should instead be corrected under the excess contribution rules. In this case, the rules that apply deal with corrections made after the extended due date. As it happens, the following 401k rollover into the same account does not change the corrective action required with respect to the ineligible rollover.
While the IRS should have caught this after the original filing year when the rollover was reported, I am not sure if they did or if you discovered the problem. In any event, the correction procedure calls for filing Form 5329 for the year of the ineligible rollover, paying the 6% excise tax for the excess contribution and doing this for each year up through 2006. If there was any year in that period that the client could have have a regular contribution to the IRA but DID NOT, the 5329 form applies the contribution he could have made against the remaining excess amount. This is done automatically by following the form. The remaining excess contribution (probably the original rollover) showing on the 2006 5329 less any amount client is eligible for as a 2007 contribution is the amount that the IRA custodian should be asked to distribute now. The custodian need not be told it is an excess correction, because these late corrections are handled simply as regular, probably early distributions. The distributed amount will be taxable on the 2007 return on line 15b. NO EARNINGS calculation needs to be done or earnings distributed and that’s the good news. The bad news is that since this will probably be an early distribution prior to age 59.5, the client will get hit with the 10% early withdrawal penalty even though he would not have been so charged with the original distribution from an inherited IRA. On top of this the IRS will probably assess interest on those prior year 6% charges.
The 2007 return will also have a 5329 attached, but this one will show that the remaining excess contribution has been distributed and no penalty for 2007.
The prior year 5329 forms should be filed and tax paid now to stop the interest clock. And the client may need to send in more estimated taxes for 2007 if the rollover amount was substantial because it will be taxable this year.
Finally, the client may want to gather documentation for a claim against that advisor for the additional taxes and penalty, and loss of deferral from the inherited IRA. The advisor should have known better. If I missed anything, please advise.
RMDs are moot since the entire rollover must be corrected. There is no way to resurrect this as an inherited IRA amount.