Form 1099-R Reporting Changes for Escheated IRAs

When an IRA escheats to a state, the IRA administrator must report the escheatment as a taxable distribution to the IRA owner on Form 1099-R.

Whether or not the owner reclaims the funds of the escheated IRA through the state’s unclaimed property rules, the full amount of an escheated IRA is taxable income to the owner.

In addition, withholding rules apply. Under transition relief, these rules apply starting whenever it is reasonably practicable for an administrator to comply, but in any case no later than 2020.

Unclaimed Property Laws and IRAs

State unclaimed property laws were put in place to reunite citizens with their lost or abandoned property while also raising revenue for the state.  Under these laws, abandoned property:

  • “escheats” to the state; and
  • is held for the owner.

The state makes some effort to find the owner. If the owner does not claim the property after a period of time, the state claims property as its own.

In the securities area, an account that lies “dormant” for a period of time is at risk of escheating to the state. The time period is usually three years. State rules vary, but typically a dormancy period starts:

  • the last date the client takes an action with respect to the property; or
  • when mailed or emailed statements are returned to the administrator as undeliverable.

An IRA is not dormant until the owner reaches age 70 ½, the age the owner must take required minimum distributions.

States Take Aggressive Stances Toward Escheating IRAs

To raise revenue, many states have tightened their unclaimed property rules to make it more likely owners will lose their property.  For IRAs, not all states condition escheatment on the owner reaching age 70 ½.

Many IRA owners take no actions regarding their IRA in the years between contributions and taking required minimum distributions at age 70 ½.  For these people, three years of returned statements risks escheatment.

State unclaimed property laws pose a challenge for IRA administrators and owners.

Escheatment of an IRA Results in a Taxable Distribution

The risk of escheatment grew significantly when the IRS ruled that a transfer to a state through escheatment is a taxable distribution, subject to reporting and withholding.

States have tried to soften the blow a bit. They might take the position that escheating an IRA is not a distribution of any sort. They might allow an owner to retrieve an escheated IRA intact by making a claim through the state law procedures.

However, the IRS’s position means that the IRS will get its cut without having to take additional money from the owner.

Notably, the Form 1099-R reporting can alert taxpayers to file for return of their unclaimed property.

Taxes and Penalties on Escheating IRAs

The downside risks for owners are considerable. First, if the IRA balance is sizeable, the owner might have an enormous tax bill for the year of transfer. Second, if the owner is under age 59 ½, the 10 percent additional early withdrawal tax may apply. Third, if the 1099-R doesn’t reach the owner because the administrator has the wrong address, penalties would accrue over time for delinquent taxes.

by James Solheim, J.D., LL.M.

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All stories by: CCHTaxGroup