There was a recent
Court decision that stunned and upset a number of tax and financial advisors.
It has to do with IRA rollovers.
We need to
be clear, though, on the type of rollover that we are talking about. There are
two ways to rollover an IRA:
(1) You have the trustee presently
handling your IRA transfer the funds to another trustee. This is done trustee-to-trustee,
and you never see the money. Let’s call this “Type 1.”
(2) You have the trustee presently handling
your money send you a check. You then have 60 days to transfer it to another
trustee. If you go past the 60 days – say 61 – you have income, and possibly
penalties. Let’s call this “Type 2.”
We are talking
today about Type 2.
The IRS
Publication on this matter is Publication 590, and here is its explanation on rollovers
from one IRA to another. For those playing the home game, the following is from
page 21:
Generally, if you make a tax-free rollover of any part of a
distribution from a traditional IRA, you cannot, within a 1-year period, make a
tax-free rollover of any later distribution from that same IRA. You also cannot
make a tax-free rollover of any amount distributed, within the same 1-year
period, from the IRA into which you made the tax-free rollover.
Example: You have two traditional IRAs, IRA-1 and IRA-2. You
make a tax-free rollover of a distribution from IRA-1 into a new traditional
IRA (IRA-3). You cannot, within 1 year of the distribution from IRA-1, make a
tax-free rollover of any distribution from either IRA-1 or IRA-3 into another
traditional IRA.
However, the rollover from IRA-1 into IRA-3 does not prevent
you from making a tax-free rollover from IRA-2 into any other traditional IRA.
This is because you have not, within the last year, rolled over, tax free, any
distribution from IRA-2 or made a tax-free rollover into IRA-2."
So the IRS
is saying that the one-year rollover limitation applies on an IRA-per-IRA
basis.
How did tax
pros work with this? Let’s say that someone has $1.05 million in an IRA. You
have him/her split this (likely trustee-to-trustee) into seven IRAs, each with
$150,000. You then have him/her roll $150,000 from IRA-1. Sixty days later,
he/she draws $150,000 from IRA-2 to repay IRA-1, thereby resetting the 60-day
clock. When that expires, he/she borrows from IRA-3 to repay IRA-2. And so on.
I have seen
this done. I have never liked it. However Publication 590 said you could, so it was considered tax legitimate.
Now we look
at Bobrow v Commissioner.
Here is the
setup:
· Bobrow received a $65,064 distribution
from an IRA on April 14, 2008
· Bobrow received a $65,054 distribution
from an IRA on June 10, 2008
· Bobrow’s wife received a $65,054
distribution from her IRA on July 31, 2008
Once you
know the technique, it is easy to see it in practice.
The IRS said
that the Bobrows had income for 2008, and it wanted taxes of $51,298, as well
as penalties of $10,260.
The IRS
laid-in with Section 408(d)(3)(B)(the bolding is mine):
408(d)(3)(B) LIMITATION.— This paragraph does not apply to any
amount described in subparagraph (A)(i) received by an individual from an individual retirement account or
individual retirement annuity if at any time during the 1-year period ending on
the day of such receipt such individual received any other amount described in
that subparagraph from an individual
retirement account or an individual
retirement annuity which was not includible in his gross income because of the
application of this paragraph.
Did you
notice the “an?” The Code does not refer to IRA-1 or IRA-2. Granted, the last
sentence goes on to say “an” IRA not includible in gross income because of the
application of this paragraph. I can see an interpretation limiting the rule to
the IRA involved in the roll and not
other IRAs the taxpayer may have. Apparently that was also the IRS’ reading in
Publication 590.
The Tax Court
said no. Its reading was one roll per year – that’s it, period. It does not
matter how many IRAs the taxpayer has. The limit applies on a per-taxpayer and not a per-IRA basis. The Court held for the IRS, even for the
penalties.
Now think
about this for a second.
The Code
outranks any IRS Publication in the hierarchy of tax authority. It has to, obviously. If an IRS publication misinterprets the Code, it is the Publication that has to step aside. It is
unfortunate for those who relied on the Publication, but I understand the tax side of this.
But I do not understand the penalties. The IRS could have granted reasonable cause to the Bobrows and abated the penalties. Bobrow would present a good reason for his tax position in order to obtain abatement. Here is a good
reason: relying on IRS Publication 590. The IRS nonetheless assessed penalties, and the Tax Court
sustained the IRS.
And that to
me is abusive tax practice. Good grief, this is like a game of three-card monte.
The decision surprised many advisors. It has certainly done away with serial Type-2 IRA rollovers.
The IRS and the Tax Court have ended the technique of using multiple IRAs as bridge loan money.
My advice? Make your rollovers trustee-to-trustee and this issue will not affect you.
My advice? Make your rollovers trustee-to-trustee and this issue will not affect you.
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