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Cleaning Up a Rollover Mistake

This case perfectly illustrates the pitfalls of rollovers.

Natalie Choate, 12/11/2009

Top estate planning and investment professionals rely on Natalie Choate's best-selling book Life and Death Planning for Retirement Benefits, often called the "bible" of retirement benefit distribution planning, for everything they need to know about the rules governing their clients' retirement plans and IRAs. Order Natalie's book for $89.95 plus shipping by calling 800-247-6553, or order online at www.ataxplan.com.

Question: In 2008, "Angie," age 48, inherited a $150,000 401(k) plan (all pretax money) from her father, "Bill," who worked at ABC Company. She instructed ABC company to send the $150,000, by direct rollover, to an "inherited" IRA at XYZ Company (an IRA provider), using the new "nonspouse beneficiary rollover" procedure under Code § 402(c)(11). She intended to open an "inherited" IRA at XYZ Company (in the name of "Bill, deceased, payable to Angie as beneficiary," or "Angie, as beneficiary of Bill"). Angie already had her own IRA (titled simply "Angie IRA account") at XYZ Company. Angie's IRA is also all pretax money; it was worth $500,000 at the time of Bill's death.

Unfortunately, for reasons that are still unclear, the inherited IRA account never got opened. When XYZ Company received the check for $150,000 payable to "Angie" and marked "401(k) direct rollover amount," XYZ apparently assumed this was Angie's OWN 401(k) money being rolled over, and they deposited the check in Angie's personal IRA.

Angie has been trying to straighten this out for over a year. XYZ refuses to send the money back to ABC, or to open an "inherited" IRA now to receive the money, and ABC refuses to even discuss the subject. ABC reported the distribution to the IRS in 2008 as a nontaxable direct rollover. XYZ Company says the only thing they can do now is distribute the erroneous contribution to Angie and report it as a pre-age 59½ distribution to her from her own IRA. So for this account that she thought she could stretch out over her life expectancy, she is now looking at immediate 100% taxation plus a 10% penalty. Help!

Natalie: First let's look at what COULD have been done to fix this if attention had been given early enough, and then we'll look at the fewer options still remaining in view of the passage of time.

There are rules for what to do if a plan pays a retiree or beneficiary more than he/she is entitled to under the plan and the individual has to pay that money back to the plan. But that's not what happened here-here, the ABC plan paid the right amount.

There are also precedents for what happens when a plan distributes money to the wrong person (for example, the plan is supposed to pay money to "beneficiary A" but because the plan misplaced the beneficiary designation form the plan pays the money to "beneficiary B" instead). However, in Angie's case, the ABC plan paid the money to the correct person (Angie); the money just went into the wrong kind of account.

So unless ABC did not correctly follow Angie's instructions, it seems to me ABC Company is off the hook. It appears that either a mistake was made at XYZ Company (perhaps they did not follow instructions from Angie about opening the new inherited IRA, or about which account to deposit the money to-or possibly even if they just randomly chose an account to put the money in without seeking instructions from Angie); or Angie made a mistake in whatever instructions she gave XYZ Company. But regardless of who made the mistake, the tax treatment is clear.

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