Make this mistake with an IRA and there's no second chance.
Ready to rollover a client's inherited nonspousal
IRA? Look out, advisor! There's plenty of danger just around the
corner, if one is not a tax specialist.
Indeed, a massive, irreversible IRA rollover mistake is lurking. It is one that could potentially cost the client tens of thousands of dollars.
This is the effect of a recent private IRS letter ruling on a nonspousal inherited IRA. The tax authorities disallowed a rollover and triggered a massive tax bill. Here are the gory details.
A trustee tried to complete a transfer of a decedent's nonspousal IRA account to a beneficiary trust by making a distribution to the trust. The trustee, at the direction of an investment advisor, intended to roll it over, which is permitted for most IRAs. But the advisor, in this case, had filled out the wrong transfer form. The advisor mistakenly believed that this was a conventional IRA rollover with no taxes due.
The advisor was wrong. "Current law prohibits beneficiaries, other than spouses, from rolling over IRA distributions," says Robert Marvin, a spokesman for the IRS. Spouses don't have the problem since they are free to roll over IRAs, Marvin notes.
So the IRS disallowed the nonspousal IRA transaction. And the IRS also would not permit the form to be amended since it was the wrong one. Inherited IRAs that go to nonspouses can't complete rollovers unless they are transferred to another inherited IRA.
Therefore, the distribution was fully taxable. Therefore, the transaction was thrown out, the IRS ruled. Therefore, it was a loss for the advisor and the client. Therefore, the advisor and the client were cooked.
The stretch-out advantages of the IRA were also destroyed in one disastrous piece of bad advice. This was advice that could possibly lead to a lawsuit. And, according to one advisor, here is the worst part: There was no second chance to get it right.
"If you do it wrong, you have no recourse. It's a problem that can't be fixed," according to Michael Kitces, a certified financial planner with Pinnacle Advisory Group in Colombia, Md.
Although in most other cases of problem IRA rollovers the IRS routinely grants a 60-day period to correct the mistakes, no such relief was, or is, available for this kind of nightmarish transaction. "Because [the] trust and its beneficiaries were ineligible to roll over the distribution from the inherited IRA into another IRA, IRS couldn't grant any amount of time to accomplish said rollover," declares the headnote of the private letter ruling, 200513032.
Neither the name of the advisor nor the amount of the IRA was disclosed in the private letter ruling. Still, Kitces says the account must have been substantial.
"We can infer that the dollar amounts must have been reasonably large, given that the holder was willing to go through the private expense of several thousand dollars to obtain legal counsel and submit for a private letter ruling," Kitces says.
That the IRS gave no leeway in this flawed transaction was no surprise to another advisor. She says that many of her colleagues don't appreciate that rollover IRA business, although potentially a big profit center, can be a very difficult line. "It is so easy to mess up this kind of business," warns Julie Welch, a certified financial planner in Kansas City, Mo. Welch, who doesn't offer investment advice, is a tax specialist.
"These kind of transfer transactions can be nightmares. And quite often they are done wrong," adds Dennis Filangeri, a certified financial planner with his own practice in Las Vegas. "Sometimes the IRS catches the mistake. Other times, they don't."
He believes the cause of the IRA rollover problem is not the changing tax code. Instead, he maintains, these kinds of problems occur owing to the limitations of the professional advisor. "Many of them are great on planning and investments but not strong on taxes," Filangeri says.
Still, one of the ironies of this Wrong Way Corrigan transaction is that it never needed to take place, advisors note. A rollover was not required. The beneficiary, if this party had received the proper direction, could have had the IRA trustee set up an inherited IRA, or a beneficiary IRA.
That would have protected the tax and investment advantages of a vehicle, which, in an average investment climate, could have generated enormous wealth. This kind of IRA lists the beneficiary's taxpayer identification number and the names of both the decedent and the beneficiary.
However, this is not what the investment advisor did. Basically, the advisor in this flawed transaction on an inherited IRA failed to understand two concepts: the difference between a rollover and a trustee-trustee transfer, which is the difference between taking cash or simply sending the money from one account to another without ever seeing the cash; and the difference between conventional IRAs and nonspousal inherited IRAs. The easy way to make this mistake is to think that the normal IRA rules apply to an inherited IRA, Kitces notes.
Normally one can take a rollover on an IRA within a certain period. And one can put the money back into a qualified account somewhere between day one and day 60. Done right, the IRA isn't exposed to taxation or penalties, Kitces explains. Indeed, in some instances, the IRS can even grant extensions to the 60-day rule, he adds.
But if the transaction is mishandled, say on a Roth IRA, then the advisor has also lost the client's tax-free growth, he warns. And in the case of the inherited IRA there is no such leeway. So the inheritor of the account will be hurt in many years, Kitces adds.
"You'll have the full IRA distribution. So no more tax deferral. All the income is recognized immediately. If the income is enough to push you into a higher tax bracket, then you'll pay it on a much higher tax rate than if you took it over time. Now all your future growth will be taxed annually because it is not in a tax-deferred account," he warns.
How much damage could be done by an advisor who doesn't know his or her tax limitations? Plenty.
As an example, if the inherited IRA is $2 million and one is in the 35% bracket, that would mean the beneficiary would immediately be liable for a tax payment of $700,000. "That's $700,000 that you could have been getting deferred growth on for possibly decades to come if you are young," Kitces says.
Taxes will be paid eventually, he notes. But the problem with this example is the beneficiary gave up all the benefits of deferred growth. They could have turned that $2 million into several additional millions of dollars over a decade or two, assuming average long-term market returns.
Losing a client might not even have been the worst of the advisor's problems. A transaction that is this bad could also lead to a lawsuit, according to Gary Schatsky, a New York attorney. "Any gross mistake on the part of the advisor opens one up to a potential lawsuit," Schatsky explains. He adds that, in this situation, the advisor "should do the ethical thing and just write a check to make up for the error."
Many advisors, Filangeri cautions, could make this kind of error. That's because they either lack the tax expertise or haven't stayed up to date on qualified plan distribution rules, Filangeri adds. He says the inherited IRA snafu cited is not unusual.
Welch disagrees. She doesn't see as many problems with IRA transfers in general. Nevertheless, she concedes that it is easy for some advisors to foul up an inherited nonspousal IRA. Why? The client and the IRS usually want a potentially complicated transaction done fast, she asserts.
The "IRS usually requires that action on an inherited IRA be taken within a year of the death of the holder of the IRA, so you better know what you are doing," according to Welch.
What happens if you do it wrong? Welch says normally the IRS will grant relief on most rollover mistakes, except in the case of inherited, nonspousal IRAs.
"Usually you can beg the IRS for relief. But in this case you're going to be stuck," Welch says. IRA rollover rules will likely be liberalized, she adds. For example, the IRS will now allow those holding an inherited nonspousal IRA to take trustee-to-trustee transfer from an employee retirement plan.
"The new rules say you can do that directly, trustee to trustee," according to Kitces. Indeed, "Section 829 of the Pension Protection Act," says Marvin, the IRS spokesman, "added a new law that permits a direct rollover from a retirement plan, including a 401(k), into an IRA for a nonspouse beneficiary."
Nevertheless, Kitces and Marvin have a caveat: The Pension Protection Act won't help the advisor who botches a transaction, as cited above, and who tries to take money out of an inherited IRA or an inherited employee retirement plan.
Filangeri believes these IRA transfer scenarios are quite risky for advisers and clients. Others are just bothersome, eating up huge amounts of an adviser's time. Tax rules constantly change. Some transfers can become bureaucratic nightmares, he says.
"If you do these transfers, do them in coordination with someone who is a tax expert," he says.