axpayers who inherit individual retirement accounts (IRAs) pay no income tax if they directly roll over the funds into IRAs in their own names. Generally, if the taxpayer receives distributions directly from the inherited IRA, the distributions are taxed, but the 10% penalty tax on premature withdrawals does not apply, even if the beneficiary is under the age of 59 1/2 .
In June 1998, upon the death of Ray Campbell, his wife Charlotte inherited an IRA with a balance of $1,010,988. In July 1998 Mrs. Campbell directly rolled over the entire amount to her IRA. She subsequently remarried, becoming Charlotte Gee.
In 2002, at the age of 55, Mrs. Gee received a $977,888 distribution from her IRA. She and her husband reported the amount as income on their 2002 joint federal income tax return but did not include the 10% penalty tax, even though form 1099-R indicated the distribution was subject to it. On their return the taxpayers stated the wrong code had been entered on the 1099-R; the distribution was from Ray Campbell’s IRA, and thus was exempt from the penalty tax. The IRS assessed a deficiency equal to the 10% penalty; the taxpayers petitioned the Tax Court for relief.
Result. For the IRS. The taxpayers stated that although there was a direct rollover from Ray’s IRA into Charlotte’s, she made no additional contributions to the account and never redesignated it as her own. Therefore, the money retained its character as an amount received by a beneficiary from an inherited IRA and the distribution was made to a beneficiary on account of a death. Thus the distribution was not subject to the 10% penalty tax.
The Tax Court agreed with the IRS that the distribution was not due to the death of her former husband and was not made to her as a beneficiary of his IRA. Although she never actually had redesignated the inherited IRA as her own, it became hers when she chose to have the funds rolled over into her IRA. Once that rollover took place, the only way for her to avoid the 10% penalty for a premature distribution was to qualify for one of the other exceptions listed under IRC section 72(t).
This case illustrates that taxpayers under the age of 59 1/2 who inherit an IRA must make a decision. They can roll over the balance into their own IRA and pay no tax, in which case distributions from that IRA before age 591/2 will be subject to the 10% penalty unless one of the other exceptions applies. Or they can receive the entire balance or periodic distributions from the inherited IRA, pay tax on those amounts and avoid the 10% penalty. As the Tax Court noted in this case, taxpayers “cannot have it both ways”—they can’t avoid the tax by rolling over the inherited IRA and, later, when premature distributions are received, claim they were due to a death to avoid the 10% penalty tax.
Charlotte and Charles T. Gee v. Commissioner, 127 TC no. 1.
Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.