IRA Transfers Have Many Tax Pitfalls

Howard and Ann Owens offer a case study in how costly a "bank error" can be when tending to your Individual Retirement Account.

The couple each had traditional IRAs with Fidelity Investments and withdrew $20,000 in 1999, when Howard was older than 59-1/2 but Ann was 58 - too young to take an IRA distribution without owing a 10 percent early-withdrawal penalty.

The Owenses didn't check their quarterly statement or notice that Fidelity mistakenly took the money from Ann's account - until after they reported the $20,000 IRA distribution on their joint tax return and the IRS wrote back asking for the $2,000 penalty payment, too.

The Owenses appealed to U.S. tax court, which ruled recently that it "has no authority to disregard the express provisions of statutes adopted by Congress, even if the result in a particular case ... seems harsh."

A little-noticed provision of the 2001 tax-cut law lets the IRS waive the legal requirement that IRA rollovers take place in 60 days, but the court noted the change affects only IRA distributions after 2001 and doesn't allow forgiveness of the 10 percent penalty.

Had the Owenses caught the mistake within that rigid 60-day limit back in 1999, they could have avoided the tax penalty, according to editor Bob Scharin of RIA's Practical Tax Strategies, a professional tax journal.

"They could have had Fidelity withdraw $20,000 from Howard's IRA and deposit the funds in an IRA for Ann, provided the deposit was made within 60 days of the original withdrawal from Ann's account," Scharin says. "Then the only tax due would have been the regular withdrawal from Howard's account."

Equally strict are rules governing IRA rollovers from 401(k)-style retirement savings accounts, employee profit-sharing plans or lump-sum pension payments when taxpayers retire or change jobs. The law was rewritten in 1992 so that the worker must arrange within a 60-day limit to leave the money in the plan of the previous employer or have it transferred directly into a new employer's plan or rollover IRA, never putting his hands on the check.

Should the employee get the money in hand for the amount of the rollover, 20 percent is automatically withheld for taxes even if the rest is deposited into an IRA. And should taxpayers hold onto the check to pay credit-card bills, put a down payment on a house, buy a car or take a vacation, they will owe state and federal income tax on the money plus the 10 percent early-withdrawal penalty if they're younger than 59-1/2.

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All these rules make IRA rollovers ripe for mistakes on the part of workers, retirees, former employers and IRA trustees.

As the Owenses' not-unsympathetic tax court noted, the IRS has been willing in more than 30 private-letter rulings recently to relax the 60-day time limit to let taxpayers repair an IRA transaction that caused the 10 percent early-withdrawal penalty - so long as the mistake was made on or after Jan. 1, 2002, the 2001 statute's effective date.

Technically, IRS private-letter rulings apply only to the taxpayer who formally requests advice.

Practically speaking, the IRS has been "so forgiving" that taxpayers have reason to hope they'll prevail if an IRA mistake catches them short, too, says CPA Ed Slott, who runs the IRAHelp.com Web site and wrote "The Retirement Savings Time Bomb ... and How to Defuse It." Among the recent private rulings he cites, the IRS:

• Let a taxpayer correct his brokerage house's mistake of withdrawing money from his tax-deferred IRA instead of his taxable stock-market account.
• OK'd reversing a bank error that deposited an IRA transfer to a non-IRA account.
• Allowed a taxpayer to reverse a trustee-to-trustee IRA transfer in which the receiving bank mistakenly put the money in a taxable Certificate of Deposit instead of a tax-deferred IRA.
• However kinder and gentler the IRS may try to be, it has limits. Some heavyweight financial advisers tested them recently, suggesting that taxpayers with money problems make an IRA rollover and treat the proceeds as an interest-free loan to themselves during that 60-day window. A taxpayer who tried the scheme got no mercy: He owes taxes plus penalties on what is now an IRA withdrawal for official purposes.