guy with head in hands looking at computer

Recently, a stock broker gave some bad advice that (could have) cost our client thousands of dollars. Let me explain…

I’m sure that when Congress designed the relatively simple idea of an Individual Retirement Account (IRA) in 1974, they had no idea how complicated it would become over the next 40 years. Fast forward to 2013 and we now have a Baskin Robins-like flavor list of IRAs, including Roth IRAs, rollover IRAs, SEPs, SIMPLEs, self-directed IRAs, and the ever-growing Inherited IRA. Yes, an Inherited IRA is just a regular IRA that someone leaves to a beneficiary; however, it comes with its own set of special tax rules and exceptions. Those special rules can be huge tax traps for the uninformed.

So here’s where the bad advice came in…

Our client’s father recently passed away, leaving him his IRA as part of his estate. Following standard procedure, his father’s brokerage firm transferred the funds into his name in an Inherited IRA (so as to retain the tax-deferred status of the account). So far so good.

Needing cash to settle some of his dad’s affairs, he then asked the broker if he could withdrawal funds from the IRA short-term, and then replace them within 60 days. (The “60-day rule” is a well-known and completely legitimate way to get emergency cash from an IRA, without paying taxes and penalties. It works fine if the cash is put back into the IRA within the 60 days.) The broker thought this was a fine idea, and gave him the go-ahead.

Unfortunately, while Inherited IRAs are very similar to traditional IRAs in many ways, this is one of several key areas in which they differ. The 60-day rule does not apply to them. So, the $37,000 withdrawal made from the Inherited IRA became immediately and irrevocably taxable. In case that doesn’t seem like such a big deal, we’re talking about a nearly $12,000 tax increase!

This is why, when consulting a financial professional, it is very important to find the right person for the job. First, you want a CFP(R) professional, who will therefore have the appropriate training to answer these types of questions. Second, you want a CFP professional who actually does financial planning, and doesn’t just use his or her CFP designation to sell products. The reason for this is just like any skill or knowledge, lack of use will cause atrophy. Just because someone passed a CFP test 10 years ago, does not mean they are up on the most current laws or research.  The best way to narrow your search to these types of planners is to look for fee-only planners exclusively. You can visit the NAPFA website for a list of fee-only planners in your area (or just call us!)

Fortunately, there is good news in this client’s case. We still had time left in the year to take some proactive tax planning measures. Using some cash now freed up from his father’s estate to live off of, we began to funnel more of his income into his own retirement plan. In addition, we hope to be able to fund IRAs for him and his wife. That will allow us to offset most of the Inherited IRA withdrawal, so the increase in his taxes will be as minimal as possible. It’s going to be a little bit of a hassle for him, but at the end of the day, it hopefully won’t cost him much come tax time.

I hope this is helpful as an example of how important IRA tax planning can be. Happy tax planning!

–Curtis