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IRS Ruling Clarifies Reported Unclaimed IRAs are Taxable

Posted By Administration, Monday, June 18, 2018

 

On May 29, 2018, the Internal Revenue Service issued Revenue Ruling 2018-17, clarifying the agency’s position on traditional individual retirement account escheatment. Specifically, the ruling states that IRA holders – or trustees – must withhold 10 percent federal income tax and issue form 1099Rs when reporting unclaimed IRAs to the states. Holders are expected to comply by Jan. 1, 2019, or as soon as it becomes “reasonably practicable” to do so.

 

“Before this ruling, the obligations regarding tax withholding for reported IRAs were unclear,” said Freda Pepper, counsel with Reed Smith’s State Tax Group. “Often, when reporting an IRA to the state, holders don’t liquidate it but rather transfer custodianship of the IRA to the state. There has been confusion among holders and the states whether that was a taxable event.”

 

The ruling clarifies that Section 3405 of the Internal Revenue Code considers “any distribution or payment from or under an IRA… as includible in gross income,” and thus subject to tax withholding by the holder/trustee. 

 

Some holders already have held this position and routinely withhold tax and issue 1099Rs for escheated IRAs. Others do not. 

 

“From a banking perspective, some are already doing this and others will need to come into line with it,” said Tom Powers, business operations analyst at U.S. Bank. “Holders in the securities industry will definitely be affected by this ruling. Their distributions aren’t as clean cut as traditional banking products because they’re dealing with full shares and fractional shares. The way states want shares reported to them makes it more cumbersome for them. The ruling also covers individual retirement annuities, which are often offered by insurance holders, so they will be affected as well.”

 

Although the IRS ruling provides clarity and paves the way for consistent practices, it creates challenges for securities holders.

 

“With securities, there has to be some sort of liquidation of the property before it is reported to the state in order to withhold the 10 percent federal income tax,” Pepper said. “This could be logistically difficult. Should they try to determine the value equal to 10 percent of the IRA’s funds and liquidate just that? Or should they liquidate the entire value, which could have other tax implications for the owner?”

 

States also face some issues resulting from the IRS revenue ruling. Some have taken conflicting positions on whether reported unclaimed IRAs require withholding. For example, Pennsylvania changed its law in 2016, making unclaimed IRAs reportable after three years of inactivity regardless of the owner’s age. Generally, an early distribution would carry a tax penalty. However, the state took the position that transfer of custodianship would not result in a taxable event. The state will need to revisit this position in light of the conflicting ruling from the IRS. 

 

Because IRS revenue rulings typically address a very specific scenario presented to them for clarification, this specific ruling covers only traditional IRAs. However, there may be implications for other retirement products as well, according to Powers.

 

“With a Roth, you can take out your principal whenever you want because you’ve already paid taxes on that, but you haven’t been taxed on the earnings,” he said. “Dividends and interest become taxable when you retire. When transferring a Roth to the state, that taxable amount gets transferred. If there are tax implications for traditional IRAs, there almost have to be tax implications for Roth IRAs as well.” 

 

While holders and states have some issues to grapple with as a result of the IRS ruling, it should help owners. 

 

“Ultimately, this should get the property to the rightful owner quicker,” Pepper said. “Once a 1099 is issued, they will become aware the IRA has been escheated, allowing them to question the transaction and claim their property.”   

 

Tags:  1099  IRS 

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