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.