Avoid Losing Tax-Deferred Status on Your IRAHas your father, or another blood relative, ever asked you to trade securities on behalf of his or her individual retirement account?If so -- and you earned even as little as a $1 commission -- the transaction is considered prohibited under federal tax laws.
That's because a long-ignored glitch in the tax code gives the Internal Revenue Service the authority to recognize the entire account balance as a distribution, rendering the balance, as of the first day of the year, subject to income tax, according to Sy Goldberg, a Jericho, N.Y.-based attorney and national expert in retirement-distribution planning.
While the provision is largely unenforced, the IRS could declare possibly hundreds of thousands of IRA accounts illegal and invalidate their tax-deferred status, a scenario that worries Goldberg. A lot of innocent people could get hurt because they don't know the rule, he says.
Section 4975 of the Internal Revenue Code defines prohibited transactions involving IRAs and employer-sponsored retirement plans. They include those between an IRA owner and disqualified person's spouses, lineal descendants and ancestors. The statute also refers to another code provision that includes siblings among the definition of family members who are disqualified from engaging in a transaction with the IRA owner.
With the size of IRAs increasing through rollovers from retirement plans, there is a good chance that the government will take a greater interest in IRAs and how they're managed, says Donald Myers, a partner with Reed Smith LLP in Washington, D.C.
The accounts of IRA owners, such as stockbrokers and financial advisers, who receive any compensation from trading their own IRA account, are also subject to the unfavorable tax treatment.
Investors often consult with trusted family members, such as stockbrokers, financial planners and insurance agents, to conduct financial transactions on their behalf, according to Mr. Goldberg, who recently submitted a memorandum to staff assistants of two Congressmen, recommending a legislative correction. Is it fair to render an entire account taxable because of a $1 commission, he asks.
A mass influx of cash into IRAs during the coming years could also invite more intense IRS scrutiny. Total U.S. retirement accumulations reached $16.4 trillion last year, the highest amount recorded and an 11% increase over 2005, according to the Investment Company Institute, a mutual-fund trade group in Washington, D.C.
The statute that applies prohibited-transaction status to IRAs evolved as an afterthought to the Employee Retirement Savings Act of 1974, or ERISA, which sets minimum standards for private sector pension and qualified retirement plans and delineates rules on the tax effects of retirement plan transactions.
Congress then enacted tax code provisions to discourage individuals from using retirement accounts as vehicles for personal self-dealing, but didn't want the rules to apply only to employer-sponsored plans, so it included IRAs in the statute. The tax code considers IRA owners to be fiduciaries to their own IRAs who cannot, therefore, receive personal benefits, such as commissions on behalf of themselves.
The fiduciary rule is really supposed to protect you from yourself, says Ed Slott, a Melville, N.Y.-based CPA and IRA expert. You're supposed to invest prudently. The fiduciary responsibilities also preclude conducting transactions with disqualified persons, such as blood-related family members.
Our attempts to discuss the fairness of the statute with lawmakers and industry leaders were met with confusion. Goldberg himself says he's been waiting for more than one year for a letter ruling from the United States Department of Labor to clarify a related issue whether the trustee of an IRA trust, who is the beneficiary's blood relative and receives commissions from the IRA, pursuant to state law, is engaging in a prohibited transaction.
Goldberg says the Department of Labor has authority to grant exemptions to the law's prohibited transaction provisions, even where IRAs are involved, because of the statute's application to ERISA.
A Department of Labor spokeswoman first directed us to the IRS, but later issued a statement saying the department hasn't received a request for an exemption concerning the payment of fees by an IRA to a relative of the IRA holder who provides services to the IRA.
The department acknowledges, however, receiving a request for guidance related to a similar issue. The spokesman says the department is working with the requestor and considering all of the issues raised by this request.
The Internal Revenue Service did not respond to numerous telephone calls and email inquires.
A spokesman for Congressman Charles Rangel (D., N.Y.) directed us to the House Committee of Ways and Means. A spokesman for that committee, which has jurisdiction over taxation, said the rules are in place to prevent self-dealing between plan assets and relatives and directed us to the Department of Labor for guidance.
We also asked spokespeople for three brokerage firms -- Merrill Lynch (MER) , Morgan Stanley (MS) and Citigroup's (C) Smith Barney -- if they have internal policies that prohibit both brokers and the firm from receiving commissions when trading IRA accounts on behalf of blood relatives. No one responded to our requests for comment.
The Securities Industry and Financial Markets Association, a New York-based industry group, originally said through a spokeswoman that the law applied only to IRA owners trading their own accounts. The spokeswoman later said the organization's lawyer was traveling and did not respond to additional requests to comment.