New IRS Ruling Creates Double Whammy for Individual Retirement Accounts Treated as Unclaimed Property

Tax, Benefits, and Private Client

The IRS recently issued a ruling describing the tax treatment of IRAs 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 individual retirement accounts (“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 a ruling, 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:

  1. Federal income taxes of 10 percent must be withheld from the amount paid to the state.
  2. 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.

What Do the New IRS Rules Mean?

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 escheating an IRA, 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.

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 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 January 1, 2019, or “the date it becomes reasonably practicable . . . to comply with those requirements.”

© 2018 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.