Road to IRS Penalties is Paved With Good Intentions

It seems simple enough; there are TV ads about it all the time and you have a friend who did it.

“It” in this case is an IRA rollover. However, as Elizabeth Beech found out, the rules that pertain to IRAs (and retirement accounts in general) are precise and often unbendable.

The Facts

Beech was named the beneficiary on her mother’s IRA and inherited the account--worth $35,358--when her mother died. In 2008, Beech decided to move the IRA to a different custodian, away from the brokerage firm her mother had used and over to a mutual fund company.

That’s when the problem began.

In May 2008, Beech took a check for the $35,358 in her mother’s IRA. The following month she deposited the entire amount in an “inherited” IRA she had established at the mutual fund firm.

Beech thought she had done the right thing and she had completed this in less than the 60-days allowed for a rollover.

However, she had made a fatal error: confusing the rules that govern an IRA “rollover” with those that govern a “trustee-to-trustee transfer.”

The Definitions

A “rollover” is when you take possession of the amount in your IRA and “roll” it into a new IRA in your name. If you don’t complete the rollover within 60 days, the entire amount becomes immediately taxable.

The government isn’t entirely heartless in this matter. The IRS has significant leniency to give people an extension if a rollover doesn’t occur in the time allowed. Among other things, legitimate causes for an extension include: a) another party- the bank, brokerage firm, your advisor, etc.- messed up and the delay wasn’t your fault; b) acts of God- such as a hurricane, snowstorm, etc.- delayed the delivery of your rollover check to the new custodian. There’s a case where one man got off the hook because he was arrested and couldn’t complete his rollover because he was in jail!

In a “trustee-to-trustee transfer,” the assets in one IRA are sent directly to the new IRA without you ever receiving a check. They are electronically transferred from Custodian A to Custodian B.

The Rules

You can move money that is in your own IRA by either method. However, you can only move assets in an inherited IRA, that is, an IRA that was owned by someone else via a trustee-to-trustee transfer. You are not permitted to take possession of the money, ever.

“Why that’s the law, I can’t explain,” says CPA and IRA expert Barry Picker, of Picker, Weinberg, & Auerbach in Brooklyn, N.Y.

Thus, Beech’s problem arose because she received a check for the amount in her mother’s IRA account. At that point she lost the right to move the money into another IRA, regardless how it was titled.

The Court’s Decision

When the IRS finally caught up with Beech she fought back. Her attorney argued that she had intended to do the right thing, citing cases where courts had given other taxpayers a break. But all of these cases involved rollovers that were not completed within the 60-day window.

The problem with Beech’s actions was not the timeframe (there is none stipulated for a trustee-to-trustee transfer), but the method she chose to move the assets.

While the judges were sympathetic, their hands were tied. “Rollovers” of inherited IRAs are illegal, regardless how quickly you complete them.

Beech had to remove the money from the IRA and pay income tax on the amount. She was actually lucky, the court could have also slapped her with a 6% excise tax for an “excess IRA contribution” and tacked on additional penalties for the four years the assets sat in the second inherited IRA.

The Lesson

“You need professional advice when dealing with inherited IRAs,” says Picker. “There are a lot of landmines.” The biggest one, he says, is that people think it’s OK to move the money into their own IRA.

Only the spouse of the decedent is allowed to move inherited IRA assets into an IRA in his/her own name.

Everyone else who inherits an IRA has to keep the assets in a separate IRA account that still lists the deceased person as the owner. This “inherited IRA” will be titled something like, “Dad’s IRA, Daughter Debbie, beneficiary.”

Also, if you are the beneficiary of an inherited IRA, don’t forget that you must take a “required minimum distribution” (RMD) each year. The size of the withdrawal is based upon your age- the younger you are (and, thus, the longer your life expectancy), the smaller the amount. If you fail to take an RMD, the penalty is severe: 50% of the amount you should have withdrawn.

Financial firms and advisors provide IRA roll over advice for free. Do-it yourself investors can create a large financial burden for themselves or miss out on great opportunities if they make one small misstep in the world of IRAS. If Beech had explained to the mutual fund company where she opened the second, ill-fated inherited IRA, one of two things likely would have happened: 1) she received correct instructions on how to move her mother’s IRA account, or 2) she got improper advice and ended up with grounds for suing the firm.

In light of the fact that mutual funds have staffs that only handle these kinds of calls every day, I think option No. 1 is far more likely.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content.

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