IRS Delivers Double Whammy to Owners of Escheated IRAs
The Internal Revenue Service recently issued a ruling describing the tax treatment of individual retirement accounts that become unclaimed property. IRA owners should be aware of this ruling and ensure that they are taking appropriate measures to avoid having their IRAs treated as inactive under an unclaimed property statute.
It is no secret that many states are searching for revenue, especially in light of the recent change to federal tax law limiting the income tax deduction for state and local taxes, which has raised the specter of wealthy individuals changing their residence to a state with lower tax rates.
One increasingly important non-tax source of revenue for states is unclaimed property, which is turned over to the states under a process referred to as escheatment. Although an individual who has had property escheated may reclaim the property from the state, for a variety of reasons the amounts that are reclaimed are considerably smaller than the amounts that are escheated.
In the case of traditional IRAs, state unclaimed property laws often trigger escheatment if the IRA experiences a period of inactivity after the IRA becomes subject to the minimum distribution requirements when the IRA owner attains age 70½. One of the criticisms of basing escheatment of a traditional IRA on post-age 70½ inactivity is that it ignores the IRS rule that an individual with more than one IRA may take their required minimum distributions from a single IRA. Roth IRAs, which are not subject to the minimum distribution requirements, are handled differently for unclaimed property purposes by states that base escheatment on post-age 70½ inactivity.
The IRS’ New Rules for IRAs That Become Unclaimed Property
The IRS recently issued Revenue Ruling 2018-17, which provides that if the trustee or custodian of an IRA turns over the IRA to a state as unclaimed property, two things must occur:
- Federal income taxes of 10 percent must be withheld from the amount paid to the state.
- The trustee or custodian is required to report the escheated amount to the IRS, on a Form 1099-R, as a taxable distribution from the IRA to the owner of the IRA, even though the amount in the IRA was paid to the state and not to the IRA owner.
IRA Owners Face Tax Uncertainties as a Result of the New IRS Rules
In one sense, the filing of a Form 1099-R reporting the escheatment of an IRA might be viewed as beneficial to the IRA owner. Assuming the IRS — if not the IRA trustee or custodian — has the IRA owner’s current address, the filing alerts the IRA owner that the IRA has become unclaimed property and provides the IRA owner with the opportunity to file a claim with the state for the return of the IRA.
If an IRA owner is able to obtain return of the escheated IRA, presumably the return of the now-taxed IRA to the IRA owner will be a nontaxable event and will create tax basis in the assets of the IRA to the extent of the amount that was reported as a taxable distribution. An explicit statement to this effect from the IRS would be helpful. However, it is unclear how the IRA owner could avoid the imposition of the 10 percent early penalty tax if the IRA owner was not at least age 59½, and the escheat occurred in a state that permits an IRA to be escheated before an the IRA owner attains age 70½.
The IRS ruling also raises the question of the steps the IRA owner might take in order to qualify for a tax-free rollover if the IRA owner would like to avoid having the IRA taxed as a result of escheat. For example, would the IRA owner be able to treat the return of the IRA from the state as a rollover or would the IRA owner have to contribute funds either from the previously escheated IRA or from another source to a new IRA. Also, to be tax-free, a rollover of an IRA must occur within 60 days of the distribution of the IRA, and it is extremely unlikely that less than 60 days will have passed between the date that an IRA is escheated and the date that the IRA owner learns of the escheat as a result of the Form 1099-R filing.
The general rule is that the 60-day rollover period can only be waived pursuant to an IRS private letter ruling. Although a request for a waiver of the 60-day period based upon the escheat of an IRA would generally meet the IRS criteria for issuing a private letter ruling, there are substantial expenses associated with obtaining such a ruling.
In 2016, the IRS issued Revenue Procedure 2016-47, creating a self-certification procedure that a person can use to claim waiver of the 60-day rollover period without having to obtain an IRS ruling. Unfortunately, Revenue Procedure 2016-47 limits its use to a list of specified reasons for missing the 60-day deadline that does not include the escheat of an IRA. However, one of the listed reasons is a distribution on account of an IRS levy where the proceeds of the levy have been returned to the taxpayer. It would seem appropriate, and a simple matter, for the IRS to extend the self-certification procedure to an IRA that has been escheated and returned to the IRA owner.
What Will IRA Owners and IRA Custodians Need to Do as a Result of the New IRS Rules?
IRA owners will need to be extra vigilant to ensure that they are taking steps to avoid having their IRAs treated as inactive under an unclaimed property statute. Although the states’ escheat laws made this a concern before the IRS ruling, the ruling increases the problems that an IRA owner would face if their IRA were treated as unclaimed property and reported to the IRS as having been distributed to the IRA owner. To avoid the IRA's escheating, the IRA owner should take such obvious steps as logging into their IRA account — if they have access online — or contacting the IRA custodian at least every few months, and IRA owners should take special care to ensure that the mailing address associated with their IRA is their current address.
Financial institutions that act as trustees or custodians of IRAs, who are already faced with potential state audits of unclaimed property, will need to put in place systems that withhold and pay over to the IRS 10 percent from any escheated IRAs and will need to prepare and issue Forms 1099-R reporting the distribution of the IRA as taxable to the IRA owner.
When Do the New IRS Rules Take Effect?
The IRS ruling states that an IRA trustee or custodian must comply with the withholding and reporting obligations in the ruling by the earlier of Jan. 1, 2019, or “the date it becomes reasonably practicable . . . to comply with those requirements.”