It raised more than a few eyebrows when Republican presidential candidate Mitt Romney disclosed he and his wife have individual retirement accounts worth as much as $100 million and that these tax-favored IRAs hold investments offshore--including in the notorious Cayman Islands. Experts say there appears to be nothing illegal about their mega-IRAs, and Romney undoubtedly has had the benefit of top legal and accounting talent.
So the real scandal might be this: IRAs are a minefield for taxpayers without such pricey advisors. Rules are surprisingly complicated, vary by type of account and carry nasty penalties.
Take a distribution from a traditional IRA before age 591⁄2 and, unless a narrow exception applies, you could owe a 10% penalty in addition to ordinary tax on the withdrawal. Miss the 60-day window for rolling IRA money from one account to another, and your entire nest egg could be taxable immediately. Forget some required minimum distribution after you hit 701⁄2 or inherit an IRA and you could get hit with a penalty equal to 50% of what you neglected to take.
How's the IRS to know about infractions? The main check on the masses comes from the IRS computers, which match against individual tax returns tens of millions of 1099-Rs reporting IRA distributions. But with the federal government desperate for money, other sources of scrutiny are on the rise. Seymour Goldberg, a Woodbury, N.Y. lawyer and CPA with an upcoming book on IRAs, says the IRS is about to start an enforcement program directed just at IRAs.
Meanwhile, as part of the IRS new "high net worth" audit program, tax pros say examiners are scrutinizing the affairs of multimillionaires--including their IRAs. FORBES also has been told reward-seeking informants have sent the IRS Whistleblower Office tips alleging that one or more members of The Forbes 400 have used their IRA money to invest in startups they ran and then took public to great profit. This could be a potential violation of rules that bar you from using your IRA to invest in businesses you control, to make yourself loans or to buy property from yourself. Such a "prohibited transaction" can render your entire IRA immediately taxable and subject to hefty penalties.
Scared yet? FORBES talked to experts and looked at a raft of recent U.S. Tax Court decisions and IRS rulings to identify some rather common IRA land mines.
The contribution glitch
If you have any sort of pension or savings plan at work and earn too much, you may not be eligible to make certain IRA contributions and could get hit with an excess contribution penalty. Check IRS Publication 590 for details.
Another gotcha: You must have what the IRS considers "earned income" to contribute. On their tax return deducting a $5,000 IRA contribution, Joseph and Rosemary Niesen of Cologne, Minn. listed interest income, annuity and pension payouts, tax refunds and Social Security benefits. What they didn't have was income from a job or net income from a side business. The Tax Court upheld the IRS disallowance of the IRA deduction. "Stupid," Rosemary fumes about the ruling. "We're just trying to get by."
Financial professionals who deal in stocks and bonds can sometimes use investment proceeds as IRA-suitable income. But they have to be careful. Veteran Wall Street trader Robert Kobell claimed a $4,500 traditional IRA deduction after receiving $72,000 in dividends and interest. No good, declared the IRS and later the Tax Court, which said Kobell "engaged in only three stock transactions, did not have any customers, and did not operate from an established place of business ... and is not entitled to a deduction for his IRA contributions." Kobell says he had taken time off that year to help care for a dying parent.
The hardship hang-up
Fair or not, there is no general exception that allows you to take money from a traditional IRA before age 591⁄2 on account of "financial hardship" without paying a 10% penalty. But a lot of people seem to think there is, and they end up in Tax Court fighting the IRS--and losing. IRS Pub. 590 lists the few narrow exceptions. For example, you can withdraw funds without penalty if you're disabled; buy a first home; and pay for higher education, health insurance and medical expenses that exceed 7.5% of your adjusted gross income.
The 10% penalty is one reason young savers who need flexibility may be better off funding Roth IRAs than traditional IRAs. For either, you can contribute up to a $5,000 a year per person ($6,000 if you're 50 or older). While you get no tax deduction for funding a Roth, withdrawals in retirement are tax free. Plus this: You can withdraw your original contribution at any time, without taxes or penalties.
No loans allowed
It's legal to take a loan from your company 401(k) account. But from your IRA it's a dreaded prohibited transaction. In one Tax Court case a Florida man whose real estate business had faltered withdrew $52,000 from his traditional IRA to meet the needs of his family of four. Since he intended to repay it, he didn't declare it on his tax return as a taxable distribution. The IRS hit him with a bill for ordinary taxes and the 10% penalty on the amount withdrawn, and the Tax Court upheld it. In a way, the taxpayer got lucky; by taxing the loan as an early distribution the IRS ignored the prohibited transaction aspect, which could have resulted in the entire IRA being invalidated and taxed.
The 60-day dance
In theory you can take money out of your IRA and deposit the cash into another IRA within 60 days and not owe tax right now. But a lot can go wrong with a do-it-yourself rollover. Whenever possible, the safe course is to have money rolled directly from one institution to another. A trustee-to-trustee transfer is absolutely necessary when dealing with an inherited IRA, which has other rollover limitations that the IRS strictly enforces.
Sometimes the IRS will grant you relief from the 60-day rule if there's a delay that's not your fault--say you were hit by a truck on your way to deposit the check. But such grace can be hard to get. And the IRS won't grant a waiver if it thinks you were trying to use those withdrawn funds, such as for bridge financing when buying a house.
