Prohibited transaction…now what?
So I have two Roth IRAs at two different stock brokers (#1 and #2) and, since one offers low commissions while the other offers DRIPs, I got into the habit of ACAT transferring money back and forth whenever I wanted to place a trade. But when I did an ACAT transfer a few months ago it seems broker #1 accidentally sent the money twice (which was automatically invested twice at broker #2) so that I now have a negative cash balance in my Roth IRA at broker #1 who has now also frozen some money I left in a taxable account with them (although it’s only a few dollars and they haven’t actually taken the money or transferred it into the IRA).
I’m pretty sure a prohibited transaction has taken place here and that at least some portion of these funds will be deemed distributed from my IRA as of January 1st of this year. But what I can’t seem to figure out is:
1. Has there been a prohibited transaction with IRA #1 or IRA #2 or both or neither?
2. When the IRS says that the IRA “ceases to be an IRA” do they mean just the account in which the prohibited transaction took place or do they mean all of my Roth IRA accounts at all custodians? There doesn’t seem to be a clear answer as to what is meant by “your IRA” in the IRS pubs.
What do you think? I’d like to make broker #1 whole, but I’m hesitant to do anything because:
I) I’m not sure if they should be paid from IRA money or non-IRA money because I’m not sure if my account with them still technically qualifies as an IRA and
II) Assuming there are no penalties/disqualifications against IRA #2, since the account at broker #1 did not have a large balance on January 1 (and also since it’s a Roth), it’d be better for me to pay the taxes due for having IRA #1 disqualified, keep the money in IRA #2, and repay broker #1 with outside cash.
Permalink Submitted by Alan Spross on Tue, 2012-11-27 17:30
Only the IRA in which the prohibited transaction occurred would be deemed distributed, not the other one.
Have you talked to them about transferring an amount back from the other Roth to make the balance positive and unfreezing your taxable account ? Have they indicated intent to report a prohibited transaction to the IRS on Form 1099R (Code 5)?
As a last resort, you might consider making an actual contribution to Roth 1 to bring the balance into positive territory. Even if it’s an excess contribution, you could transfer an additional amount from Roth 2 to Roth 1 and then remove the excess contribution.
I would work with them on a solution that avoids the 1099R Code 5. Even the excess contribution will not help if they have already determined to issue that 1099R.
Permalink Submitted by Jose Morales on Tue, 2012-11-27 17:48
The overdrawing of account #1 could be seen as an extension of credit from the custodian to the IRA [b]IF[/b] you had caused the account to be overdrawn and they had no systematic way of preventing that from happening. If it is documented that you requested only one transfer of assets and it is the custodian’s fault that your one request was processed twice, I’d be hard pressed to see how a prohibited transaction occurred rather than an error on the part of the broker. Is there a reason the second erroneous transfer cannot be recalled or the funds just be transferred back to account #1?
Permalink Submitted by Slappy Cakes on Tue, 2012-11-27 18:59
Alan thanks so much for your response…
I guess the thing is I am not sure that I should be trying to avoid a code 5 because if only the Roth IRA with the negative balance will have a code 5 reported on the 1099R then isn’t it true that?:
A. I have to report a distribution of whatever the FMV of this account (Roth IRA #1) was on 01/01/2012, but there is no tax due on this distribution as long as this amount is less than my net total Roth IRA contributions (across all accounts) that are older than 5 years old (which is true in my case).
B. I get to keep the money inside the other account (Roth IRA #2) without any excess contribution penalty or prohibited transaction there.
So the end result (after I pay off the negative balance in the “former Roth IRA” #1 which is now demoted to an unqualified taxable account) is that I have effectively increased the current-year contribution to my compliant Roth IRA #2 without any additional tax or penalty.
So although my custodian has not indicated an intent to report a prohibited transaction to the IRS on 1099R (Code 5), I’m wondering why shouldn’t I encourage them to do so? Only thing is that there were also some other transactions with the possibly-now-disqualified Roth IRA #1 between the beginning of the year and when the prohibited transaction occurred such as another trustee-to-trustee transfer and an indirect rollover…but the indirect rollover was small so I guess the main thing is what would a prohibited transaction imply about the validity of trustee-to-trustee transfers in/out of the disqualified account and if they were somehow invalidated would it imply any negative consequences for me?
[quote=”[email protected]“]The overdrawing of account #1 could be seen as an extension of credit from the custodian to the IRA [b]IF[/b] you had caused the account to be overdrawn and they had no systematic way of preventing that from happening. If it is documented that you requested only one transfer of assets and it is the custodian’s fault that your one request was processed twice, I’d be hard pressed to see how a prohibited transaction occurred rather than an error on the part of the broker. Is there a reason the second erroneous transfer cannot be recalled or the funds just be transferred back to account #1?[/quote]
I’m not sure if this could fairly be called “the cause” but the mistake is not a total mystery because I did make a second request after the first didn’t appear to go through (even though I also submitted a signed letter rescinding the first request before issuing the second a few days later). However, IRS Pub 590 seems to say that prohibited transactions can also be errors on the part of the broker and ascribes an additional tax penalty to the broker in that case (on page 45):
[quote=”Pub 590″]
Taxes on prohibited transactions. If someone other than the owner or beneficiary of a traditional IRA engages in a prohibited transaction, that person may be liable for certain taxes. In general, there is a 15% tax on the amount of the prohibited transaction and a 100% additional tax if the transaction is not corrected.
Loss of IRA status. If the traditional IRA ceases to be an IRA because of a prohibited transaction by you or your beneficiary, you or your beneficiary are not liable for these excise taxes. However, you or your beneficiary may have to pay other taxes as discussed under Effect on you or your beneficiary, earlier.[/quote]
The funds could be ACAT transferred back to account #1 in another trustee-to-trustee transfer if I were willing to take the small loss from the investments I had in account #2 before the error occurred, but I’m not sure if that would really count as a recall or eliminate the prohibited transaction treatment because the “loaned” funds (if that’s what they are) have already been accruing returns and, as described above, it might also be better for me to have it coded as a prohibited transaction so I can then pay the broker back with money from my taxable accounts…what do you think?
Permalink Submitted by Alan Spross on Tue, 2012-11-27 19:49
The code does not appear to address the IRA transactions that occurred after the 1/1 deemed distribution of the account. With the Roth distribution rules and the minimum values it does not appear that a Code 5 would amount to much of a penalty for you, but there could be some unintended consequences so generally the Code 5 is best avoided. Otherwise, you would just report a Roth IRA distribution of Form 8606 for the amount shown on the 1099R (assuming the 1099R would be correct from this broker may be overly optimistic). The distribution would come from your basis in regular contributions and be tax and penalty free.
Roth #2 should be unaffected by all this unless the IRS chose to require the funds you transferred out from Roth 1 to be distributed as well. Initially, the IRS will go by the amount shown on the 1099R so you would hope the broker just shows the 1/1 balance. You would then no longer have a Roth IRA with that broker.
Pub 590 explains the consequences in terms of a traditional IRA only, and the taxes and penalties would not apply or be much reduced with a Roth account closure.
Permalink Submitted by Slappy Cakes on Tue, 2012-11-27 22:49
Alan,
Inspired by your last comment I decided to look at the Internal Revenue Code itself which appears to say that:
1. It’s actually only prohibited transactions “engaged” by the owner/beneficiary of the IRA that would trigger the distribution/disqualification. As suggested by urusei2 if a prohibited transaction is the custodian’s fault then the IRA is not disqualified/distributed even though the custodian itself incurs a hefty tax liability for their transgression.
2. Even aside from whose fault it is, it appears this loan transaction isn’t prohibited at all because fiduciaries to the IRA who don’t have discretionary authority/control and don’t provide investment advice are exempt as “disqualified persons” for the sale, lending, and transfer prohibitions….and it makes perfect sense because how else could the brokerage collect fees or cash checks for the IRA?
3. If the IRA were to be retroactively disqualified and distributed effective January 1 then it appears that any trustee-to-trustee transfers occurring after that date would be invalid because the trustee-to-trustee transfer appears to arise from the fact that “all individual retirement plans shall be treated as 1 contract” (when adding up distributions), but since a disqualified account is no longer an IRA it cannot be treated as such and, thus, the trustee-to-trustee transfer actually becomes an undocumented excess contribution (to the compliant IRA). This is scary because there doesn’t appear to be any way to rectify this, but it is interesting to note that a 60-day rollover of the forced January 1 distribution is completely valid.
[quote=”section 408″]
(e)(2) Loss of exemption of account where employee engages in prohibited transaction
.
.
(A) In general
If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph—
(i) the individual for whose benefit any account was established is treated as the creator of such account, and
(ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account.
(B) Account treated as distributing all its assets
In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).[/quote]
[quote=”section 4975″]
(c) Prohibited transaction
(1) General rule
For purposes of this section, the term “prohibited transaction” means any direct or indirect—
.
.
(B) lending of money or other extension of credit between a plan and a disqualified person;
.
.
.
(d) Exemptions
Except as provided in subsection (f)(6), the prohibitions provided in subsection (c) shall not apply to—
.
.
(20) transactions described in subparagraphs (A), (B), and (D) of subsection (c)(1) between a plan and a person that is a disqualified person other than a fiduciary (or an affiliate) who has or exercises any discretionary authority or control with respect to the investment of the plan assets involved in the transaction or renders investment advice (within the meaning of subsection (e)(3)(B)) with respect to those assets, solely by reason of providing services to the plan or solely by reason of a relationship to such a service provider described in subparagraph (F), (G), (H), or (I) of subsection (e)(2), or both, but only if in connection with such transaction the plan receives no less, nor pays no more, than adequate consideration,
.
.
.
(f) Other definitions and special rules
For purposes of this section—
.
.
(6) Exemptions not to apply to certain transactions
(A) In general
In the case of a trust described in section 401 (a) which is part of a plan providing contributions or benefits for employees some or all of whom are owner-employees (as defined in section 401 (c)(3)), the exemptions provided by subsection (d) (other than paragraphs (9) and (12)) shall not apply to a transaction in which the plan directly or indirectly—
(i) lends any part of the corpus or income of the plan to,
(ii) pays any compensation for personal services rendered to the plan to, or
(iii) acquires for the plan any property from, or sells any property to,
any such owner-employee, a member of the family (as defined in section 267(c)(4)) of any such owner-employee, or any corporation in which any such owner-employee owns, directly or indirectly, 50 percent or more of the total combined voting power of all classes of stock entitled to vote or 50 percent or more of the total value of shares of all classes of stock of the corporation.
[/quote]
[quote=”section 408″]
(d) Tax treatment of distributions
(1) In general
Except as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.
(2) Special rules for applying section 72
For purposes of applying section 72 to any amount described in paragraph (1)—
(A) all individual retirement plans shall be treated as 1 contract,
(B) all distributions during any taxable year shall be treated as 1 distribution, and
(C) the value of the contract, income on the contract, and investment in the contract shall be computed as of the close of the calendar year in which the taxable year begins.
For purposes of subparagraph (C), the value of the contract shall be increased by the amount of any distributions during the calendar year.
(3) Rollover contribution
An amount is described in this paragraph as a rollover contribution if it meets the requirements of subparagraphs (A) and (B).
(A) In general
Paragraph (1) does not apply to any amount paid or distributed out of an individual retirement account or individual retirement annuity to the individual for whose benefit the account or annuity is maintained if—
(i) the entire amount received (including money and any other property) is paid into an individual retirement account or individual retirement annuity (other than an endowment contract) for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution; or
(ii) the entire amount received (including money and any other property) is paid into an eligible retirement plan for the benefit of such individual not later than the 60th day after the date on which the payment or distribution is received, except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph).
For purposes of clause (ii), the term “eligible retirement plan” means an eligible retirement plan described in clause (iii), (iv), (v), or (vi) of section 402 (c)(8)(B).
(B) Limitation
This paragraph does not apply to any amount described in subparagraph (A)(i) received by an individual from an individual retirement account or individual retirement annuity if at any time during the 1-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an individual retirement account or an individual retirement annuity which was not includible in his gross income because of the application of this paragraph.[/quote]
http://www.law.cornell.edu/uscode/text/26/408
http://www.law.cornell.edu/uscode/text/26/4975
Permalink Submitted by Alan Spross on Tue, 2012-11-27 23:47
1) But was this transaction the custodian’s fault? That appears to initially be decided by the custodian if they proceed to issue the 1099R. That is why I recommended that you try to get them to accept a transfer from the other IRA to eliminate the frozen account and restore a positive balance to the IRA. You might check your IRA adoption agreement to see if the broker discloses this course of action should a negative balance occur. I think the broker is not particularly pleased with processing the 1099R and would rather avoid it. If the custodian interprets the negative balance as your fault AND also a prohibited transaction, then they should issue the 1099R. If you take the position that this situation is NOT your fault, the amount in question is so small, it is probably not worth a protracted dispute with the custodian.
2) I am not even sure this is really a loan from your taxable account OR a prohibited transaction. It certainly could be an implied loan, but does freezing your taxable account equate to a transfer to your IRA or not? Perhaps it is just a leverage maneuver to get you to restore a balance in the IRA. You are considered a fiduciary with respect to your own IRA and also a disqualified person (self dealing), but you did not freeze the account, they did and their action may not be justified.
3) You could not do a 60 day rollover unless you knew of the 1/1 distribution within 60 days of that date. While the code is not clear, it appears to me that the 60 day rollover option based on when you receive the funds does not apply here as disqualification on 1/1 would mean that you are deemed to have received the funds back on 1/1.
It probably is a waste of time to engage a broker with an acedemic discussion of prohibited transactions and whether their action was justified under the circumstances. But depending on the outcome you wanted, you might be able to influence them to either avoid the 1099R or to proceed with issuing it in January or sooner.
Permalink Submitted by Jose Morales on Thu, 2012-11-29 17:03
Has the custodian of IRA #1 given any indication of what they want to do in this situation?
Permalink Submitted by Denise Appleby on Fri, 2012-11-30 13:17
[quote=”[email protected]“]So I have two Roth IRAs at two different stock brokers (#1 and #2) and, since one offers low commissions while the other offers DRIPs, I got into the habit of ACAT transferring money back and forth whenever I wanted to place a trade. But when I did an ACAT transfer a few months ago it seems [color=#FF0000][b]broker #1 accidentally sent the money twice [/b][/color](which was automatically invested twice at broker #2) so that I now have a negative cash balance in my Roth IRA at broker #1 who has now also frozen some money I left in a taxable account with them (although it’s only a few dollars and they haven’t actually taken the money or transferred it into the IRA).
I’m pretty sure a prohibited transaction has taken place here and that at least some portion of these funds will be deemed distributed from my IRA as of January 1st of this year. But what I can’t seem to figure out is:
1. Has there been a prohibited transaction with IRA #1 or IRA #2 or both or neither?
2. When the IRS says that the IRA “ceases to be an IRA” do they mean just the account in which the prohibited transaction took place or do they mean all of my Roth IRA accounts at all custodians? There doesn’t seem to be a clear answer as to what is meant by “your IRA” in the IRS pubs.
What do you think? I’d like to make broker #1 whole, but I’m hesitant to do anything because:
I) I’m not sure if they should be paid from IRA money or non-IRA money because I’m not sure if my account with them still technically qualifies as an IRA and
II) Assuming there are no penalties/disqualifications against IRA #2, since the account at broker #1 did not have a large balance on January 1 (and also since it’s a Roth), it’d be better for me to pay the taxes due for having IRA #1 disqualified, keep the money in IRA #2, and repay broker #1 with outside cash.[/quote]
First- I did not read all of the follow-up comments (time availability issue) – so if this was addressed later- my apologies.
If the broker ‘accidentally’ delivered the amount twice, that is not a prohibited transaction. That is an error made by the financial institution. A reclaim of the duplicated transfer should resolve the issue. Steps should be taken to ensure that cash us available to satisfy the reclaim.