Internal Revenue Service rules around retirement accounts are so complex that it can take an expert to unravel them all.
A minor misstep can lead to mind-boggling penalties, but taxpayers who understand the labyrinthine rules sometimes abuse them to avoid taxes, said Ms. Choate, an estate-planning and retirement benefits attorney with Nutter McClennen & Fish LLP, speaking at the InvestmentNews 2012 Retirement Income Summit.
Head-slapping mistakes are by far the most common, Ms. Choate said.
Consider the 40ish employee who left a job and walked away with a check for the value of his 401(k) account. He sent the check to his bank accompanied by a note directing the money to his IRA, but the bank mistakenly put the money in his checking account instead. He didn't notice for months, long after the 60-day deadline for a tax-free rollover.
“Nobody likes to look at their statements,” Ms. Choate said. “I hear about these cases all the time.”
According to IRS rules, the money should be taxed as income and subject to a 10% penalty for an early withdrawal from a retirement account.
But that mishap can be fixed, Ms. Choate said. So can many others, if you know the rules.
In the case of the jobless employee, the key is to request a hardship waiver, which the IRS frequently grants.
As evidence, Ms. Choate polled the audience of several hundred advisers on how many had clients who faced the issue of failing to take a minimum distribution from a retirement account, an oversight which is punished with a 50% penalty on the amount of the required distribution.
Taxpayers can request a waiver of that penalty, too, and out of 11 advisers in the audience who had clients in that predicament, 10 said their waiver requests were approved.
Minor mistakes that lead to big tax bills can devastate a retiree's account, but the audience asked the most questions about what Ms. Choate said was an abusive way of sheltering gains on a hypothetical stock purchase by moving the money between retirement accounts.
She described a hypothetical situation which drew most of the questions from the audience. It involved an investor who deposited $100,000 into a
Roth IRA and bought stock with the money. Later, after the stock had appreciated, the investor took advantage of a rule that allowed him to undo the deposit, but he left the gain in the account, where theoretically, it was not subject to capital gains taxes.
She warned that such abuses eventually could lead the IRS to get rid of Roth IRAs altogether, although so far, she hasn't seen the IRS go after anyone for such transactions.
