Natalie Choate offers up some lesser-known remedies for common IRA mistakes.
There are lots of ways a client's retirement benefits can get messed up--and even more ways to fix the problems. Here are some of the remedies, mostly for IRA mistakes, with emphasis on those fixes most people have never heard of.
Almost any contribution to a Roth IRA or traditional IRA can be "recharacterized" as a contribution to the other type of IRA, by moving the contribution (plus any earnings or losses accrued since the contribution was made) to the other type of account.
This remedy is well known as a way to reverse (undo) a Roth conversion, but it is not limited to that use. A client can recharacterize if he simply changes his mind about which type of IRA he wants to make his annual IRA contribution to; when a rollover that was supposed to go into a Roth IRA goes into a traditional IRA by mistake; or if the client erroneously makes his annual IRA contribution to a Roth IRA when he was only eligible to contribute to a traditional IRA (or vice versa).
There is a deadline for recharacterizing an IRA contribution: Oct. 15 of the year after the year the contribution was made. But if you miss that deadline for good cause (for example, a professional advisor's error), you can apply to the IRS for an extension.
Only two types of IRA contribution cannot be recharacterized. One is a tax-free rollover: For example, if a client rolls money from his traditional 401(k) plan account to a traditional IRA (a tax-free rollover), then later decides he would have been better off to transfer that money to a Roth IRA, he cannot make that change.
Also, the client can recharacterize only if he would have been eligible to make the original contribution to the other type of IRA. For example, if 73-year-old Joe, who is still working, makes a $6,000 regular IRA contribution to a Roth IRA, then realizes he is not eligible to do so because his income is too high, he cannot fix the problem by recharacterizing the contribution over to a traditional IRA because he is too old to contribute to a traditional IRA. He would need to use the next remedy:
Withdraw IRA Contribution by Extended Tax Return Due Date
Any regular contribution to an IRA that is withdrawn from the account (along with any earnings or losses that accrued to the contribution between the date it was made and the date it is withdrawn) by Oct. 15 of the year after the year of the contribution is treated as if it had never been made to the IRA. (There is one exception: The earnings withdrawn with the contribution are subject to the 10% penalty if the individual is under age 59½).
This "it never happened" treatment applies both for purposes of the 6% penalty on excess IRA contributions (which helps "Joe" in the previous example, who otherwise would have to pay a penalty for contributing to a Roth IRA when he was not eligible to do so), and for purposes of the income tax treatment of the distribution. So the distribution is not taxed under the "cream in the coffee" rule that normally causes IRA distributions to be deemed to come proportionately from pre- and after-tax money in the individual's IRAs. This "corrective distribution" remedy not only helps someone who is facing a penalty, it helps anyone who simply wishes after the fact that he hadn't made the contribution at all.
The Tax Code and IRS regulations read as if a "distribution" from a retirement plan is a decisive, discernible, irreversible physical event, like a beheading: Money is either inside the plan or it is out of the plan, and once the asset has been "distributed" it's going to be taxable, unless it is an eligible rollover distribution and gets promptly rolled over to another retirement plan.
But it turns out not to be quite so black and white. Sometimes, after money has been distributed from a plan, it can be "undistributed." I was unaware of this remedy until recently, but I am told that it is definitely not rare.
Here's how it works: A plan or IRA distributes money--for example to a nonspouse beneficiary from an inherited plan or IRA. Then the distributee and advisors realize that the distribution should not have happened, and the money can't be rolled over to another plan (because nonspouse beneficiaries are not entitled to roll over distributions from inherited plans). Often this situation arises because of mistakes by the plan or IRA administrator--for example, the administrator erroneously told the beneficiary he could roll over the distribution. The administrator may be persuaded to take back the distribution--put the money back in the plan and walk back all the paperwork to erase the distribution "trail" (including filing a corrected 1099-R, if necessary). There is no official blessing for this approach, although it did meet with IRS approval in PLR 2011-39011.
Escaping the One-IRA-to-IRA-Rollover-Per-Year Rule
Mary wants to move her IRA from one provider (X) to a different IRA provider (Y). X does not want to cooperate. Mary requests an IRA-to-IRA transfer of the entire account. X refuses and instead gives Mary a check for part of her IRA balance, which Mary rolls over to the new IRA at Company Y. X disputes with Mary, claiming that the rest of the assets in her IRA at X are not transferable. Eventually X begrudgingly agrees to close the account, but again refuses to do a direct IRA-to-IRA transfer, and gives Mary a check for the remaining IRA balance. Trouble is, both checks were received within 12 months of each other, and there is a rule prohibiting rolling over to an IRA a second distribution received from an IRA that was involved in a prior IRA-to-IRA within the preceding 12 months. Mary's choices:
--First she should try to persuade IRA provider X to undistribute the second distribution and redo the transfer as a direct IRA-to-IRA transfer.
--If that doesn't work, another alternative is to rely on PLR 2011-05047, in which two distributions received from the same IRA within 12 months were apparently regarded by the IRS as a single distribution for purposes of the one-per-year rule. Perhaps the IRS treated the two checks as a single distribution because the participant had requested a total distribution in the first place, not two distributions, and the IRA provider had simply complied with the request piecemeal. Or perhaps the IRS just didn't think of this issue (it was ruling on a different issue). I would recommend "relying" on this ruling only if the second distribution has already been rolled into the new IRA.
--The surest way to finesse the problem is to roll the second distribution into a Roth IRA (Roth conversion). A Roth conversion is not subject to the one-per-year rule. If Mary doesn't want a Roth IRA (she does not want to pay the income tax that a Roth conversion would generate), she can recharacterize the conversion. A recharacterization is also not subject to the one-per-year rule!
Resources: For a review of all the ways of fixing IRA mistakes, see Natalie's Special Report: IRAs with Hair: How to Fix an IRA with a Shady Past," which may be purchased and downloaded by clicking here. Alternatively, for a complete discussion of recharacterization, including all the rules for the applicable deadline, see ¶ 5.6 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011); the book also covers corrective IRA distributions.
For discussion of the private letter rulings cited above, see the free downloadable Special Report: Recent Developments.