IRAs are great financial tools that carry valuable tax advantages, and are an important part of many clients’ portfolios. When IRAs are part of an estate, however, they are subject to rules that are highly inflexible. When survivors receive advice that does not address these rules adequately, there can be disastrous financial consequences.
A ruling handed down in U.S. Tax Court in December provides one such tax horror story, and it could easily have been avoided. It is worth recounting in detail to uncover lessons that could help advisers in creating estate plans that include IRAs.
The case involved the estate of a Florida man, Thomas W. Ozimkoski Sr., who died in August 2006. Just seven months before his death, Ozimkoski executed a will that left the bulk of his property to his wife, Suzanne D. Oster Ozimkoski, and named her as personal representative of his estate. At the time of his death, Ozimkoski had a traditional IRA at Wachovia and a 1967 Harley-Davidson motorcycle.
He also had a son, Thomas Jr., who was unhappy about the will. The son went to probate court and faced off against Suzanne, his stepmother. The IRA custodian, Wachovia Securities, froze the funds in the IRA pending the outcome of the litigation.
When the dust settled, a settlement had been reached. Suzanne would pay Junior the sum of $110,000 and transfer title of Senior’s motorcycle to him. The settlement provided that the payment would be made within 30 days of the date on which Senior’s IRA was unfrozen by Wachovia. The settlement also said that “all payments shall be net payments free of any tax.”
CARRYING OUT THE SETTLEMENT
The motorcycle transfer seems to have gone smoothly, but the same was not true of the payment of the IRA funds.
On July 2, 2008, Wachovia transferred $235,495 from the deceased’s IRA to an IRA set up in Suzanne’s name. Suzanne took a distribution from her IRA and wrote a personal check for $110,000 to Junior to make the payment required under the settlement agreement. She also took other distributions from her IRA in 2008 for a total of $174,597.
Wachovia issued a 2008 Form 1099-R showing taxable distributions of $174,597 to Suzanne in 2008. The distributions were coded as early distributions because Suzanne took them from her own IRA and she was under age 59 ½.
Suzanne filed her 2008 federal income tax return late and reported only her wage income from the Boys and Girls Club, just under $15,000. She did not report any of the IRA distributions as income.
The IRS subsequently issued a notice of deficiency to Suzanne for 2008. The IRS said she owed $62,185 in taxes and a 10% penalty on the IRA distributions. It also hit her with an accuracy-related penalty of $12,437. Suzanne disagreed and brought her case to the Tax Court, representing herself.
The Tax Court held that Suzanne owed income taxes, the 10% early distribution penalty and part of the accuracy penalty. The court did not buy Suzanne’s argument that the IRA distributions should not be included in her income because Junior was entitled to $110,000 of the IRA under the settlement agreement. Instead, the court agreed with the IRS that the distributions were taxable to Suzanne because they were from her own IRA.
WHO IS THE BENEFICIARY?
The Tax Court began its decision by tackling the important issue of exactly who was the beneficiary of Senior’s IRA. Generally, the beneficiary of an IRA is whoever is named on the IRA beneficiary designation form. However, there was a problem. Wells Fargo, the successor to Wachovia, did not have Senior’s IRA beneficiary designation form. It is unclear whether the form had never been filled out or somehow went missing.
In the absence of the form, the estate became the beneficiary by default. Because Suzanne inherited through the estate, the IRA became a probate asset, which can be subject to a will contest. If the beneficiary is named on IRA beneficiary form, however, the account bypasses probate and goes directly to her.
Because the estate, not Suzanne, was the beneficiary of the IRA, Wachovia “incorrectly” rolled it over to her IRA, according to the court. What Wachovia should have done, the court said, was distribute the IRA assets to Senior’s estate rather than to Suzanne’s IRA. The court said it had no jurisdiction to fix that mistake.
The court expressed sympathy for Suzanne, noting that her attorney during the probate litigation clearly failed to counsel her on the tax ramifications of paying Junior from her own IRA. However, the court said it could not change the fact that the distributions she received were from her own IRA and, therefore, taxable income.
The court also said Suzanne owed the 10% early distribution penalty on the funds taken from her IRA. There is such a thing as an exception to the penalty for distributions due to death, but that did not apply to her. This is because a spouse beneficiary may no longer claim the exception if she rolls over the funds from her deceased spouse’s IRA into her own IRA and then withdraws the funds from her IRA.
The court gave Suzanne a break on the accuracy penalty. The court said that in light of all the circumstances, including her limited experience, knowledge and education, she had acted in good faith with respect to the portion of her underpayment attributable to her failure to include in her taxable income the $110,000 she paid to Junior. However, she was still liable for the penalty on the other IRA distributions she took.
This case offers several lessons for advisers and their clients:
The importance of beneficiary forms. It’s easy to imagine another, much happier, outcome in this case. When Thomas Ozimkoski Sr. updated his will to leave everything to his wife, he should also have updated his IRA beneficiary designation form. If he had, the IRA would have passed directly to her and never became part of the disputed probate estate.
A competent adviser would have realized that any payment coming from an IRA will be taxable. If one party is not paying the tax, then someone else is.
The need for competent advisers. One thing that Suzanne Ozimkoski lacked in this case was advisers who understood the IRA rules. She needed a knowledgeable attorney who could have advised her better on the outcome of her settlement agreement.
A competent adviser would have realized that any payment coming from an IRA will be taxable. If Junior is not paying the tax, then someone else is. A competent adviser would have realized Wachovia’s error and had the custodian reverse the transaction and retitle the inherited IRA properly.
Naming a spouse on the beneficiary designation form allows her to roll over the funds to her own IRA. This avoids the result in this case, where the estate was the beneficiary and the rollover was “incorrect.”
Avoid “incorrect” rollovers. Naming a spouse on the beneficiary designation form allows her to roll over the funds to her own IRA. This avoids the result in this case, where the estate was the beneficiary and the rollover was “incorrect.”
With proper advice, the spouse could have elected to remain a beneficiary rather than do a spousal rollover. By remaining a beneficiary here, the spouse could have taken distributions she needed and avoided the 10% early distribution penalty.
A positive outcome in one court may be irrelevant for tax purposes. The settlement agreement said that all payments to Junior shall be net payments, free of any tax, and the widow was under the impression that she owed no taxes. But tax rules did not allow this outcome. During the settlement process, someone should have advised her that there was no way to avoid the tax on the IRA distribution.
After the mistaken rollover, the Tax Court could not unwind that transaction and instead had to decide the widow’s tax liability based on the erroneous transfer of the IRA assets to her own account and her subsequent distributions.
How the death exception to the 10% penalty actually works?
This exception to the penalty is for beneficiaries, but does not apply when the spouse rolls the retirement funds over to his or her own IRA. Once a spousal rollover occurs, the spouse is then the IRA owner and not a beneficiary.
If you sound confused, let me help you!
Tom Cooper, CFP.
A study from Fisher Investments 401(k) Solutions found that 80 percent of millennials say they would prefer to work for a company that offers a 401k plan, dispelling a commonly-held belief that millennials are not as interested in 401k plans as other generations.
However, despite their high levels of interest, millennials also tend to be (understandably) less educated on the ins and outs of retirement planning, with the same percent (80) failing Fisher’s 401(k) IQ in the Workplace Quiz. That’s higher than the 70 percent of general respondents who earlier failed the same workplace quiz, missing at least three of the nine basic questions.
“We’re encouraged that the vast majority of millennials recognize that 401k plans can be indispensable to meeting their long-term savings goals,” Nathan Fisher, managing director and founder of Fisher Investments 401(k) Solutions, said in a statement. “However, when you get down to the nuts and bolts of planning, it becomes clear there’s an education gap”.
The Fisher study also found that millennials are more likely than other groups to receive and trust information about retirement planning from individual contacts, whether they be friends, relatives or co-workers, countering the view that younger savers are more reliant on internet-based information and advice.
In fact, nearly one in three millennials trust a friend or family member’s advice on retirement planning most. In keeping with their desire for individual attention, millennials are more likely than other age groups to wish their retirement provider would reach out to them personally, and to know more about their company’s 401k plans.
Millennials at small businesses (which Fisher defines as those with between 5 and 200 employees) tend to be less engaged in retirement planning, with nearly one in four saying they are not enrolled in a plan.
Those who are enrolled in a plan are also less likely to receive information from their 401k provider than their counterparts at larger companies, and, perhaps most troubling, they are less likely to trust the 401k plan offered by their employer.
The survey also found some stark differences between millennial women and men. Millennial women are much less confident in their ability to pick the right investments and save enough for retirement than their male peers. They are also less likely to be enrolled in their company’s 401k plan and more likely to fail the 401(k) IQ Quiz.
“This study really strikes at the heart of the assumptions many employers and planners have about the millennial generation,” Fisher continued. “While they are very technologically savvy, millennials are in fact the most likely generation to seek individual rather than web-based information about their retirement plans. We were also surprised to find that a significant gender gap continues to exist when it comes to investing and retirement planning, something that employers and 401k providers must address.”
NAMCOA has updated a “SMA vs Mutual Funds” educational piece outlining the differences of SMAs (“Separately Managed Accounts”) and Mutual Funds. It can viewed by clicking here.
This education piece has a long history, originally prepared by Paul McIntyre in 1995 when he was a Trainer at PlannerChoice in Detroit, a regional professional education firm that was dedicated to assist financial advisers transition from “commission-based” to a “fee-based” relationship with clients, with a goal to reduce portfolio costs and conflicts of interest found in commission products.
It was updated again when McIntyre was the Dean of Adviser Development in 1998 at RunMoney in San Diego, a national Separately Managed Account platform that private labeled its own SMA platform for Broker Dealers, Banks and Insurance Company’s, which later become part of Fidelity. Versions of the educational piece were also used at UBS in early 2002 to help clients learn about their portfolio management options.
McIntyre states “The most important aspect of any marketing or content driven information piece is Education. Investors consistently need to learn ways to reduce portfolio management expenses, gain greater tax efficiency and transparency in their portfolio to better meet financial objectives“.
The Naples Asset Management Company, LLC Office will be closed November 24th & 25th in observance of the Thanksgiving Holiday.
In awareness that the market is open on Friday we will have a member of our team here for trading purposes.
From us here at NAMCO, we wish you a wonderful and safe Holiday Weekend.
Business will resume as normal on November 28th, 2016.
Walter Hester, Senior Portfolio Manager of the NAMCO Monthly Needs Portfolio, has updated his portfolio performance. Click here to view namco-09-30-2016-quarterly
This NAMCO Monthly Needs Portfolio is a non leveraged, diversified portfolio, actively managed with an objective of providing long term capital appreciation and dividends.
The Portfolio adheres to a simple strategy of investing in a weighted portfolio of 25 stocks consisting of sectors that the average consumer spends monies on each month.
The Portfolio focuses primarily on U.S large-cap value stocks, but can invest in mid to small cap equities and foreign companies as well. The portfolio does not use any leverage.