In Summer of 2013, my wife’s mother passed away. My wife was the beneficiary of her mother’s TIRA with my 2 adult daughters as contingent beneficiaries. My wife decided to disclaim the IRA, so the IRA would be split between daughters. The bank that was custodian of her mother’s IRA provided form to disclaim, and forms each daughter to fill out to identify custodian and account for their Inherited IRA. Forms were returned to bank and we awaited further instruction. Instead, with no further communication, the bank sent 2 checks directly to the daughters’ custodian. However, daughters had not yet had time to set up an IRA account at their new custodian (they already had checking and savings accounts there). When the checks arrived at the new custodian (a regional FCU), the clerk who processed the checks couldn’t find an IRA for the deposit, so the clerk deposited both checks into my youngest daughters checking account. My daughter did not discover this until a week or so later when she called me to ask why her checking suddenly had ~$60K deposited to it. I realized from the amount what had happened and we immediately contacted the new custodian. This resulted in a meeting with the resident IRA ‘expert’ at the new custodian. The ‘expert’ was in disbelief that they would have done such a thing, but she pulled up electronic photocopies of the checks that were deposited, and the photocopies showed that the checks were made out “[Wife Mother’s Name](deceased) FBO [My Daughter’s Name]” and included daughter account number. One check for each daughter. ‘Expert’ admitted they had deposited checks to wrong account in error, but said it could be fixed. Each daughter needed to open an IRA. Then the ‘expert’ would then transfer the correct amount from youngest daughter’s checking to each IRA. [‘Expert’ couldn’t roll back and re-deposit the checks as checks had already cleared during time it took us to discover error.] During this process, we repeatedly asked if the new IRAs were appropriately titled as Inherited IRA. ‘Expert’ said that it would show up as an IRA in their account, but that their system would ‘know’ that it was an inherited IRA. We left the meeting with belief that everything was as it should be.

I tell that story to bring us to the present day. Late last year, I reminded my daughters that they needed to take a RMD from the IRA in order to preserve their right to stretch the IRA over their lifetime. They each took a RMD prior to end of 2014. Two weeks ago, my youngest daughter asked for help with preparing her income taxes because the tax software was telling her that she owed a penalty for early withdrawal from the IRA. I told her that was wrong, no penalty for distribution from Inherited IRA. However, when I look at the 1099-R she received as a result of the RMD from the IRA, I see it shows a “1” in Box 7 instead of a “4”. I figure the FCU has incorrectly coded the 1099-R and tell her she needs to go to local branch and ask them to issue her a corrected 1099-R. She went today and I went with her as had some business in the area. The conversation with the FCU CSR did not go well. The CSR understood Inherited IRAs and agreed that 1099-R was incorrectly coded for distribution from an Inherited IRA. However, she could not find an Inherited IRA in my daughters account, only a TIRA. We told her that was incorrect, that the only IRA my daughter had was the one created as beneficiary of her grandmother’s account. The CSR said she would need to consult with FCU IRA expert and would call us back later in the day. My daughter got the call and the FCU states that they have no record of daughter opening an Inherited IRA. Their system shows that she only has a TIRA in her name as owner and thus the 1099-R cannot be corrected.

It is apparent 1.5 years later that the IRA was not set up correctly in their system even though at the time we repeatedly stated that the IRAs needed to be appropriately titled as Inherited IRAs (same titling as on checks from original custodian). We are in process of scheduling meeting with newest IRA ‘expert’ (the old one retired) to try to get this resolved. I’m not optimistic this will go well.

At meeting with IRA ‘expert’, we plan to ask that they retrieve the photocopies of the original checks to prove that the IRAs should have been set up as Inherited IRAs. We don’t have copies of checks as they were trustee-to-trustee. I did see the electronic photocopies at the 2013 meeting, but regretfully did not ask for copies for ourselves. I fear that because of their original error, FCU may take position that these checks were never deposited into IRA, that IRAs were funded from youngest daughter’s checking account. The only records that my daughters have from setting up the IRAs is a standard form for opening an IRA (Name, Address, SSN, etc.) and a beneficiary designation form. Neither form indicates type of IRA.

Now for my questions for this forum:
I’m not sure that this is a problem that can be fixed by ‘re-titling’ the IRA as apparently the IRA was never set up as Inherited IRA initially. I’m concerned that the IRS might consider money was deposited into daughter’s own IRA accounts even though they never had an IRA until one was created to receive funds as beneficiary of grandmother’s account. Is this a valid concern? If so, what are tax consequences?

Can daughters file Form 5329 with tax return to take exception to incorrect coding of 1099-R issued by FCU?

If audited by IRS, are records from original custodian sufficient to show that no early withdrawal penalty should be assessed due to death of original owner, with daughters as beneficiaries?

What have I not thought of?