Using IRA Funds to Settle a Probate Dispute

IRA Funds to Settle a Probate Dispute

Inherited IRAs can present a number of challenges. In Ozimkoski v. Commissioner, T.C. Memo. 2016-228, the court considered the tax implications of a withdraw from an inherited IRA that was used to settle a probate dispute with the couple’s son. The case shows what not to do when using IRA funds to settle a probate dispute.

Facts & Procedural History

The facts and procedural history of the case are as follows:

  • The taxpayer’s husband died and his will left all of his assets to the taxpayer.
  • The couple’s son contested the husband’s will.
  • The bank that held the husband’s IRA froze the account pending the outcome of the litigation.
  • The taxpayer eventually entered into a settlement agreement whereby her son was to be paid $110 thousand.
  • The bank transferred $235 thousand of the husband’s IRA into the taxpayer’s IRA.
  • The taxpayer then took at $141 distribution from her IRA and wrote a check to her son for $110 thousand settlement payment.
  • The taxpayer reported the $141 thousand distribution and paid tax on it. She did not report a 10 percent addition to tax on the $141 thousand distribution.
  • The IRS assessed a 10 percent additional tax on the $141 distribution from the taxpayer’s IRA.

The Tax and Addition to Tax for Early Withdrals

Taxpayers must pay tax on distributions they receive from IRAs. Taxpayers are also subject to a 10 percent additional tax on withdraws from IRAs if the withdraws are taken before the taxpayer reaches age 59-1/2. There is an exception to the 10 percent additional tax for withdraws by a surviving spouse from the deceased spouse’s IRA if the distributions are made due to the decedent’s death. The taxpayer argued that this exception applied and that she was not subject to the 10 percent additional tax. This was the primary issue addressed by the court.

As noted in the case, the courts have previously concluded that:

once the assets in the decedent’s IRA were transferred into the taxpayer’s IRA, any subsequent distributions were no longer occasioned by the decedent’s death and were not made to the taxpayer as a beneficiary of the decedent; therefore, the exception … did not apply.

In applying this rule, the court determined that the taxpayer was liable for the 10 percent additional tax.

Avoiding the Tax and 10 Percent Addition to Tax

With a little foresight, the taxpayer could have avoided the tax and the 10 percent addition to tax altogether. Had the taxpayer not transferred the $235 thousand to her account, but had instead left it in her husband’s IRA and paid the $110 thousand to her son directly from her husband’s IRA, she would not be subject to tax on the distribtion and the 10 percent penalty would not have applied.

The taxpayer could have rolled part of her husband’s IRA into an inherited IRA for her son. With this arrangement, the son would have had to start taking distributions from the IRA immediately or within 5 years and the distributions would be subject to tax. It appears that the taxpayer’s son was aware of this rule, as the son had told the bank that he did not want an inherited IRA. With the settlement, the son was able to receive $110 thousand free of any tax, while shifting the liability for the tax and addition to tax to his mother.

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