An IRA owner sometimes has a claim against an investment advisor or a company for losses in connection with products or services provided to the IRA. Such a claim may be based on fraud, misappropriation, breach of contract, or other default in duties owed to the customer, or it may simply be part of a class action brought on behalf of many shareholders. The IRA owner normally brings the claim (or joins the class action) in his own name, not in the name of the IRA; a custodial IRA is not an "entity" that can file a lawsuit or claim.
If the IRA owner, in his own name, recovers money on such a claim, the question becomes, how can this money be restored to the IRA? If he just deposits the money into the IRA, wouldn't that be an "excess contribution?"
In the context of qualified plans (such as a 401(k) plan), a recovery on a claim like this is allowed to be paid into the plan as a "restorative payment," a replacement for the losses in question, and as such the IRS does not consider it a contribution to the plan. Therefore, it is not subject to the rules and limits applicable to plan contributions.
The IRS similarly has allowed IRA owners to contribute this type of recovery to their IRAs. See, for example, 11 apparently related IRS 2004 private letter rulings in which IRA owners sued an insurance company for improperly selling them certain annuities for their IRAs. The IRS ruled that the IRA owners' net proceeds from the lawsuit (which they received in their individual names) could be deposited into their respective IRAs, and these deposits would be treated as tax-free rollovers. Apparently, the date the defendant paid the money it owed was considered the date of the distribution from the IRAs--the IRS gave the owners 60 days from that date to complete the rollovers.
In those 11 PLRs, the IRS ruled that the contributions were valid rollovers and did not use the term "restorative payment" or cite any authority for its conclusion. In contrast, other PLRs with a similar outcome do use the term "restorative payment," cite IRS Revenue Ruling 2002-45 as authority, and do not generally refer to the additions as valid rollovers--though many note that the amounts were contributed to the IRAs within 60 days of receipt. See, for example, PLR 2007-14030; and PLR 2007-05031, in which a surviving spouse was allowed a late rollover of an amount paid as a settlement for investment losses caused to her deceased husband’s IRA by an advisor's malfeasance.
If a restorative payment to an IRA is considered a rollover, then would the once-per-12-months rule normally applicable to IRA-to-IRA rollovers (Internal Revenue Code § 408(d)(3)(B)) be triggered? In PLR 2007-19017, the IRS ruled that this type of addition was "not subject to...§ 408(d)(3)."
The ability to contribute a restorative payment to an IRA applies only to the compensatory payment for the actual investment loss (PLR 2008-50054); it does not extend to any portion of the award or recovery that represents attorneys' fees or court costs (PLR 2007-24040), punitive damages (PLR 2008-52034), or interest (PLR 2009-21039). "Attorneys' fees" here means the amount paid to the attorney out of the compensation payment, even if that is more than the amount denominated as "attorneys' fees" in the damage award (PLR 2008-52034). A restorative payment can include a payment received from the defendant in a good faith settlement and/or arbitration (see PLRs 2007-38025, 2007-24040, 2009-21039) as well as a litigation recovery.
What if the IRA experiences losses due to the malfeasance of a crooked investment seller who is financially unable to repay those losses? Can the IRA owner use his/her own money to make a compensating restorative payment to the IRA? Unfortunately, the answer to that one is no, according to the IRS. Only an amount recovered from the malefactor (whether through a lawsuit or settlement) can constitute a restorative payment. You can't just substitute your own funds to replace IRA investment losses, even if those losses were caused by the malfeasance of others.
Where to read more: See Rev. Rul. 2002-45, 2002-2 CB 116; PLR 2006-04039; PLRs 2004-52043–2004-52046, 2004-52048–2004-52054 (PLR 2005-34026 is similar); PLR 2001-51051; and 8.1.05, in Chapter 8 of Natalie Choate’s book Life and Death Planning for Retirement Benefits (8th ed. 2019), www.ataxplan.com. For the once-per-12-months rule see 2.6.05. For extensions of the 60-day rollover deadline, see 2.7.05.
Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie's book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.