72t issue…can it be corrected?
Have a client who had two IRA’s with another custodian of which one was in 72t payout. We were not told of one being 72t and through a trustee to trustee transfer we combined both IRAs. This was done about 2 months ago. He then came to us asking about his monthly payout he was receiving and this is how we discovered one was a 72t. Up to this point no funds have been distributed so the question is can we open a new IRA and transfer the funds that were from the 72t into this IRA continue with distribution and the client avoid the penalty for modification?
Permalink Submitted by Alan Spross on Mon, 2009-07-20 18:59
Quite a few taxpayers have 72t plans set up where the original balance was based on more than one IRA account, but the actual distributions were only taken from one IRA. So the first question here is to examine the 72t calculation documentation to determine the derivation of the opening account balance. If both accounts were combined for determining the opening balance, then there is no problem with these transfers.
However, if only one account was used for the calculations, then this 72t plan has been busted by this transfer, even given that direct transfers are non reportable transactions. If a letter ruling was requested to allow an earnings calculation to be done on the combined account, and the earnings adjusted amount transferred back out, there would probably be a decent chance of a favorable ruling if the client did nothing to initiate the combining of accounts. The IRS has issued quite a few favorable “error correction” rulings recently when the error was not the client’s fault. This might be the case here, even though the client certainly should have told you that he had an active 72t plan in force, and then you would NOT have made the transfer. Unfortuneately, PLRs of this type are costly, about $10,000 plus legal fees.
Permalink Submitted by Jeremy Polk on Mon, 2009-07-20 20:46
Is there any chance that since this just happened a month ago, we can say it was an invalid rollover and if we put the funds back into the IRA within the 60 day rollover period it would not be a busted 72t?
Permalink Submitted by Alan Spross on Mon, 2009-07-20 21:24
Sorry, no. Following is copied from RR 2002-62 which addresses modified 72t plans:
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(e) Changes to account balance. Under all three methods, substantially equal periodic payments are calculated with respect to an account balance as of the first valuation date selected in paragraph (d) above. Thus, a modification to the series of payments will occur if, after such date, there is (i) any addition to the account balance other than gains or losses, (ii) any nontaxable transfer of a portion of the account balance to another retirement plan, or (iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable.
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As you can see, (i) above is what occurred and the plan was busted instantly upon receiving the transfer. That said, reversing the transfer to a new non 72t IRA account would not save the plan, but would be advisable to support a letter ruling request for relief based on the client not knowing about or authorizing the transfer. So there is no downside to transferring these funds out by direct transfer, but that in itself would not save the plan. The 60 day rollover limit does not apply to direct transfers, and it is better not to do indirect rollovers since that would result in a 12 month limit before doing another one. It is best to avoid indirect rollovers generally, but more so when executing a 72t since they are non reportable to the IRS and preserve the safety valve of having an indirect rollover available in an emergency.
Other questions to be addressed are the year this 72t plan began and if the amount distributed still fits the funding needs. If the plan is new, then perhaps only a couple years of penalties would accrue, and if the plan is not new but no longer serves the needs, there may be some need to bust the plan anyhow and start a new one. Client may be able to report a voluntary bust of the plan as of 12/31/08 and avoid 2009 penalties and start a new plan in 2009. So there are various ways to determine whether the funds should be spent on a letter ruling or just report the plan as busted. The problem with rolling the dice and doing nothing is that the IRS is not efficient in detecting busted plans. They may not detect it for a couple years, perhaps never, or perhaps toward the end when the interest charges on the penalty would be almost as much as the retroactive penalties themselves.
So this is a tough decision, even without the issue of assessing the amount of blame the client has for the transfers, which would in turn affect the chance for a favorable IRS letter ruling. Moving the improperly transferred funds out to a new IRA account would at least show the IRS good faith if the letter ruling is going to be requested.
Permalink Submitted by Jeremy Polk on Tue, 2009-07-21 13:18
Alan….thanks for all the info. The problem is this payout was started back in 1990 and over $150,000 in distributions have been made under the plan so my understanding is this would result in a $15,000 penalty as it goes back to inception of the payouts. We were really hoping since we caught the error in the same tax year that it could be corrected without a penalty being imposed but it appears that is not the case.
Permalink Submitted by Alan Spross on Tue, 2009-07-21 18:47
1990! A 19 year plan is about the longest I have heard of. In this case, the $15,000 penalty would only be the tip of the iceberg because the IRS levies interest charges on each year’s penalty presumably using the various quarterly underpayment rates. At least the indicated annual payout is less than 8,000, much smaller than average, but with interest he may be looking at closer to $30,000 in total charges. A PLR request would be somewhat over $10,000, and it may be a decent time to attempt one since the IRS is more sympathetic than usual with declining retirement account balances. But unfortuneately, there are no quick and inexpensive fixes out there.