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Seymour Goldberg
Seymour Goldberg
Legal Headaches Involving Roth IRAs

Why you should care.

April 22, 2010
by Seymour Goldberg, CPA, JD

Roth IRAs present estate and income tax planning opportunities for many clients, especially in 2010. This results from the elimination of income limitations and filing status requirements that would have applied to Roth IRA conversions prior to 2010.

Prior to 2010 if the modified adjusted gross income of a client exceeded $100,000 or if the client was married and filed separately, then he/she was not eligible to convert a traditional individual retirement account (IRA) to a Roth IRA. As of 2010 these restrictive rules no longer apply.

Many advisors suggest that traditional IRAs be converted into Roth IRAs if the economics make sense. The economics include many factors such as income tax projections, estate planning considerations and many other issues as well. Indeed, the benefits of Roth conversions are manifold, to those for whom it makes sense. A complete discussion is beyond the scope of this article. But, along with the possible benefits, are many “legal headaches” as well.

Case Study

Assume that client Stuart converts his traditional IRA of $1 million to a Roth IRA on January 15, 2010. His advisor, Carl tells him that if the Roth IRA tanks during 2010 or up to October 15, 2011 (if Stuart meets certain Internal Revenue Service (IRS) requirements), that Stuart can avoid being taxed on his 2010 conversion. Carl explains to Stuart that the process of avoiding income taxes on the 2010 conversion is done by means of a timely re-characterization of his Roth IRA back to his traditional IRA. Carl tells Stuart that if his 2010 return is timely filed by April 15, 2011 then he automatically can re-characterize the Roth IRA by October 15, 2011. Alternatively, if Stuart files an IRS extension by April 15, 2011, he also gets to the October 15, 2011 date to re-characterize his Roth IRA back to his traditional IRA.

The beneficiaries of Stuart’s traditional IRA were originally Jack and Jill as equal beneficiaries. Stuart selects his son Jack as the sole beneficiary of the Roth IRA since Jack is in a low income tax bracket. Carl was advised by Stuart that Jack was selected as the sole beneficiary of Stuart’s Roth IRA because he is not doing well financially. Jack’s financial future does not look good.

Jill married a plastic surgeon who makes $2 million a year and takes care of Jill in the manner that she became accustomed to.

Jack is a struggling artist whose prospects for earning high income in the future do not look that good.

Stuart decides to make Jack the sole primary beneficiary of his Roth IRA and Jill the contingent beneficiary. Carl had nothing to do with Stuart’s decision regarding the change in beneficiaries. Jill is not aware of Stuart’s decision. Although Jill is married to a plastic surgeon, she believes in equality of treatment and would not be happy about the change in beneficiaries.

Stuart is divorced and has made adequate provisions for his prior wife, Mary, in his will. Stuart’s will also provides that his residuary estate is to be divided equally between Jack and Jill.

On April 1, 2011, Stuart filed for an extension to file his income tax return to October 15, 2011.

Assume that on August 1, 2011, the market tanks and Stuart’s Roth IRA account drops to $800,000. Stuart contacts Carl and asks Carl to arrange for the paperwork to re-characterize his Roth IRA back to his traditional IRA.

Carl prepares the paperwork for Stuart to sign to arrange for the re-characterization of the Roth IRA to the traditional IRA but because of vacation plans Carl postpones meeting with Stuart to sign the paperwork until the end of August 2011.

On August 15, 2011, Stuart suffers a severe stroke. His chances of recovery are slim to none. He is not capable of signing any paperwork or making any decisions regarding any matter.

Carl becomes concerned about the re-characterization issue and meets with Jack and Jill.

At that point Carl asks Jack whether or not Stuart has a power of attorney so that someone can act on behalf of Stuart.

It turns out that Stuart had an old power of attorney that appointed Jack and Jill as Stuart’s agents.

Jack agrees to re-characterize Stuart’s Roth IRA to a traditional IRA on Stuart’s behalf as long as he (Jack) continues to be sole beneficiary of a traditional IRA for Stuart. Jill says no way. Jill wants to be an equal beneficiary of a traditional IRA established for Stuart.

In order to make things worse, Stuart’s power of attorney requires that both Jack and Jill act together (jointly) in exercising any decisions with respect to Stuart.

In addition, the power of attorney is liberal and states that any member of the family can be selected as the beneficiary of any retirement account, including IRAs (subject of course to spousal consent requirements under ERISA). An IRA is not subject to Employee Retirement Income Security Act (ERISA).

What Happens?

Jack would have to litigate the issue before the state court in order to obtain the authority to re-characterize the Roth IRA to a traditional IRA and also to have the state court determine that he is the sole beneficiary of the traditional IRA.

The theory of the litigation would be based upon the fact that Jack is acting in the best interest of Stuart under Stuart’s power of attorney and that Jill is in violation of her fiduciary duty to act in the manner that Stuart would have acted had he not been incompetent.

Obviously, the litigation would drag on for a number of months and would not be resolved by the October 15, 2011 deadline.

Assume that Jack won the case in March 2012. Jack would have to obtain a late re-characterization private letter ruling from the IRS based on the delay that was triggered by the litigation. This procedure is both expensive and time consuming.

If Jack decided not to litigate because of estimated litigation costs, then Jill would have to litigate the issue. If Jill did not wish to litigate and Jack did not litigate, then Jack would not have the authority without a court order to re-characterize Stuart’s Roth IRA to a traditional IRA on Stuart’s behalf without Jill’s cooperation because the power of attorney required joint action.

Obviously Jack may be ahead of the game if the re-characterization does not take place since Jill in essence is absorbing 50 percent of the income taxes that are triggered on the conversion income of $1 million.

Suggested Approach to Avoid the Problem

Stuart should consider creating a new power of attorney whereby he has selected Jack as his primary agent and Jill as his successor agent.

In addition, he should have specific language involving the discretion of the agent to re-characterize a Roth IRA to a traditional IRA. In addition, the agent should be given the authority and direction to select the beneficiaries or beneficiary of the traditional IRA that receives the Roth IRA assets by means of a re-characterization. The power of attorney could state in essence that the traditional IRA beneficiaries or beneficiary, as the case may be, of the re-characterized Roth IRA shall be identical both in name and percentages that the Roth IRA had.

Further, as of September 1, 2009 in New York State if the agent (i.e., Jack) has the authority to select the beneficiary or beneficiaries of a retirement account, then specific language must be included in the power of attorney. In addition, as of September 1, 2009 if the agent may select himself and/or herself as the beneficiary or one of the beneficiaries of a retirement account, then the specific name of the agent (Jack) must also be stated in the power of attorney.

The New York rules described above apply to powers of attorney executed on or after September 1, 2009. Different rules apply to New York powers of attorney that were executed prior to September 1, 2009. In addition, if a New York power of attorney was executed prior to September 1, 2009, it is still valid except if the client executed another New York power of attorney on or after September 1, 2009. In that case many new detailed rules apply to New York powers of attorney entered into on or after September 1, 2009.

Each state has its own power of attorney rules. Clients must be careful in preparing powers of attorney regarding changes of beneficiaries of retirement accounts, insurance policies, annuity contracts, etc.

If Stuart had no power of attorney then a legal guardian appointed by the court would have to handle both the re-characterization issue as well as the beneficiary issue.

If Stuart had a power of attorney that provided for retirement benefit transactions but the power of attorney lacked provisions for the selection of beneficiaries of retirement accounts, then a legal guardian appointed by the court would have to handle the beneficiary issue.

For more related case studies, please view full 14-page report (PDF).

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Seymour Goldberg, CPA, MBA, JD, is a senior partner in the law firm of Goldberg & Goldberg, P.C., Woodbury, New York. He is Professor Emeritus of Law and Taxation at Long Island University. He is the recipient of the American Jurisprudence Award in Federal Estate and Gift Taxation from St. John's University School of Law. He is the recipient of outstanding discussion leader awards from both the American Institute of Certified Public Accountants and the Foundation for Accounting Education. He was formerly associated with the Internal Revenue Service. Goldberg is the author of numerous books, including his latest, Can You Trust Your Trust: What the Practitioner Must Know, (017271PDF) available from the AICPA, through www.cpa2biz.com or by calling the member service hotline at (888) 777-7077.