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s recently as March 2010, it was estimated that there is over $4.3 trillion invested in IRAs (“Retirement Snapshot, First Quarter 2010”, Investment Company Institute), and another $12 trillion, if you look at the entire retirement plan market (Ibid.). These numbers reflect the fact that over 40% of US households have an Individual Retirement Account (IRA).
Even though these investment accounts permeate our financial lives, few professional advisors, much less the individual owners themselves, really know the rules governing individual retirement accounts.
The challenge is that due to the complications of the tax code, everyday occurrences can cause an IRA to be completely and fully distributed for tax purposes. Additionally, if the IRA is considered distributed for tax reporting purposes, it has probably lost any asset protection as an asset exempt from the claims of creditors as well.
Prohibited Transactions and IRAs
As a general rule, IRAs are accounts that are exempt from taxes on their earnings (26 USC 408(a)). The beneficiary is only taxed when taxpayers start taking distributions from the IRA (26 USC 408(d)).
If the IRA engages in a prohibited transaction as per 26 USC 4975(c), the IRA ceases to be an IRA as of the first day of the taxable year the prohibited transaction occurred. Furthermore, the account is treated as if it made a distribution, at fair market value of all it assets as of the first day of the taxable year (26 USC 408 (e)(2)).
For example, Joe has a $100,000 IRA on January 1, 2009. On October 31, Joe engages in a prohibited transaction with his IRA, now valued at $75,000. Since the account is no longer an IRA, Joe has not only lost all future tax deferral, but he now owes taxes on $100,000 of income as that was the value of the account on January 1.
Among other things, a prohibited transaction is defined under 26 USC 4975(c)(1)(b) as “lending of money or other extension of credit between a plan and a disqualified person.” The IRA owner is considered a disqualified person to the IRA.
Brokerage Agreements Create Prohibited Transactions
In general, a requirement of opening an IRA with a brokerage firm is to agree to the brokerage firm’s standardized “brokerage agreement.”
A typical term in the brokerage agreement is a requirement for the client to personally guarantee the account and/or grant the brokerage firm a lien on all other assets including personal accounts the client may have at the firm.
Recently, we requested a ruling from the Department of Labor as to whether such language would be considered an extension of credit and thus a prohibited transaction. (Under Reorganization Plan No. 4 of 1978, effective December 31, 1978, the authority of the Secretary of the Treasury to issue interpretations regarding section 4975 of the Code was transferred to the Secretary of Labor. The Secretary of the Treasury is bound by the interpretation of the Secretary of Labor pursuant to such authority.) In October of 2009, the DOL released Opinion 2009-3A. In its Opinion, the DOL stated, “Here, the requested granting of a security interest in the assets of the IRA owner’s personal accounts to the broker to cover the IRA’s debts to the broker is akin to a guarantee of such debts by the IRA owner. This would amount to an extension of credit from the IRA owner to the IRA."
Didn’t think a brokerage firm could require such a guarantee? Read some of the following and come to your own conclusions:
“Security Interest. As security for the repayment of my present or future indebtedness under the Account Agreement or otherwise, I grant to XXXX Investments a first, perfected and prior lien, a continuing security interest, and right of set-off with respect to all securities and other property that are, now or in the future, held, carried, or maintained for any purpose in or through my Brokerage Account or Settlement Choice and any present or future accounts maintained by or through you or your affiliates,” Brokerage Firm A.
“Granting a Lien on Your Accounts. As security for the repayment of all present or future indebtedness owed to us by each Account Holder, each Account Holder grants to us a first, perfected and prior lien, a continuing security interest, and right of set-off with respect to, all property that is now or in the future, held, carried or maintained for any purpose in or through XXXX, and, to the extent of such Account Holder’s interest in or through,” Brokerage Firm B.
Ramifications
Based upon the ruling by the DOL, it appears there are millions of zombie IRAs. While the average citizen and professional advisor are acting on the belief the IRA is “qualified,” there is a very high likelihood the IRAs are not qualified and are instead mounting up very large tax bills.
Even more troublesome is the fact that transactions that would normally be commonplace with “qualified” IRAs do nothing but add more to the unknown tax bill.
Consider rollovers and transfers of IRAs. In order to rollover or transfer from one IRA to another, you obviously need a “qualified” IRA as the starting point. If the account is no longer an IRA that would mean non-qualified funds are being transferred into a qualified fund. Under the tax code, these “excess” contributions are subject to a 6% excise tax each year they remain in the plan (26 USC 4973).
Example: Steve had an IRA worth $100,000. In 2005, he opened an account for his IRA at a brokerage firm that required him to personally guarantee the account. His account would be considered fully distributed as of January 1, 2005. In 2007, Steve rolled what he thought was an IRA into an IRA with a new brokerage firm. If the account was still $100,000, Steve is now liable for an excise tax of $6,000 a year in addition to any other taxes that came due when he engaged in the inadvertent prohibited transaction.
By the way, right now the hot financial planning topic is to convert a traditional IRA over to a Roth IRA.
What happens if someone doesn’t have a traditional IRA anymore? Are they allowed to convert what is now merely a personal investment account into a Roth? No. Instead of building up tax-free income, they are building up 6% annual excise tax fees.
Another concern is the bankruptcy protection given to IRAs. In most jurisdictions, IRAs are considered exempt assets, not subject to the claims of their creditors.
If in fact the IRA has engaged in a prohibited transaction, the IRA is no longer an IRA and thus no longer an exempt asset. I personally know of a number of bankruptcy trustees who are now reviewing debtor’s IRAs to see if they have run afoul of the prohibited transaction rules.
Conclusion
If your client has an IRA, they need to make sure that neither they nor the IRA have inadvertently engaged in a prohibited transaction that would cause the IRA to be fully distributed and fully subject to taxes. If in fact they have run afoul of the IRS rules on IRAs, they need to immediately contact a professional to start the IRS retroactive relief process.
Tim Berry, Esq., specializes in issues with retirement plans and has been asked to provide numerous continuing education classes on the topic. You can reach him at
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