Tax-loss harvesting can be used as an opportunistic value-add within a well-diversified portfolio.

Finds evidence of overcharges for transactions, postage

By Bruce Kelly September 7, 2011 3:42 pm ET

Living up to its warnings of this year, the Financial Industry Regulatory Authority Inc. said today that it has walloped several firms for overcharging for postage and handling.

In May, Finra chief executive Richard Ketchum warned an audience of brokerage executives at the self-regulator’s annual meeting in Washington that it was making inquiries into firms’ overcharging clients for such services. This morning, Finra said it fined five firms a total of $910,000 for overcharging clients on handling transactions.

Mr. Ketchum earlier said: “We are taking a close look at excess charges for routine services, which some firms appear to be treating as an additional de facto commission. You can expect to see some enforcement activity in this area with respect to particularly egregious examples.”

Finra today said in a statement that the five firms were “understating the amount of total commissions charged to customers in trade confirmations and on fee schedules by mischaracterizing a portion of the commission charges as fees for handling services.”

Firms allegedly were using the practice to gouge clients, Finra said. “With respect to each of these firms, the handling fees were designed to serve as a source of additional transaction-based remuneration for the firm and thus were far in excess of the cost of the handling-related service the firms provided.”

The five firms and respective fines were: Pointe Capital Inc. of Boca Raton, Fla., fined $300,000; John Thomas Financial of New York, $275,000; First Midwest Securities Inc. of Bloomington Ill., $150,000; A&F Financial Securities Inc. of Syosset, N.Y., $125,000; and Salomon Whitney LLC of Babylon Village, N.Y., $60,000.

To continue reading, go to FINRA fines five firms almost $1M over fees

Seeking the help of financial professionals has become more important to investors according to a recent survey conducted by Harris Interactive on behalf of TD Ameritrade Holding Corporation, as nearly one quarter (22 percent) of investors report relying more on a professional investment advisor following the recession (1).

Even if you have a good handle on your investments, you may find that hiring a financial advisor — who can put the time and energy into making sure you and your family plan for a secure financial future — may be a worthwhile investment. By hiring an independent registered investment advisor — commonly referred to as an RIA — you can make sure your investments are managed on a full-time basis by a professional advisor, while still having control.

Of course deciding to put someone in charge of your hard-earned money is not a process to be taken lightly. TD Ameritrade offers these tips to consider as you choose an independent financial advisor or RIA:

• Just as it is wise to do research on the background of anyone who would take care of your children, you should investigate the person or company you enlist to handle your money. The Securities and Exchange Commission, Inc. (www.adviserinfo.sec.gov), Financial Industry Regulatory Authority (www.finra.org), Certified Financial Planner Board of Standards (www.cfp.net), National Association of Personal Financial Advisors (findanadvisor.napfa.org/Home.aspx), and Financial Planning Association (www.fpanet.org), as well as your own state securities agency all collect background information on financial professionals that can be accessed through their websites. Use these sites to make sure the advisors you are considering haven’t faced disciplinary action for dishonest practices and are in good standing with regulators.
• Know the difference between working with an independent RIA and a stock broker, or other financial services provider. Independent RIAs, for example, are bound by law to act in their clients’ best interest. Brokers, on the other hand, are held to a “suitability” standard, meaning the advice they give must be suitable to that client’s situation. If you are looking for objective, comprehensive money management, you might want to consider an RIA.
• While RIAs are required by law to act in your best interest, there are other ways that you can ensure they will do what is best for you. One is to ask how they are compensated. Fee-only compensation generally minimizes conflicts of interest and means that your advisor is paid only for the management services and advice he or she offers, and only by you, not by investment product providers. When an advisor is paid on commission, there’s a greater chance he or she will make choices with your money that serve not only your interests, but their own as well. That’s not to say that advisors do not work fairly under this model, but potential conflicts of interest are something to consider as you choose an advisor.
• When looking for referrals from friends or relatives, the most valuable referrals may come from those in similar situations. It’s also a good idea to ask potential advisors if they specialize in working with certain types of clients and choose one that fits your unique profile.
• Check to make sure your advisor’s firm is audited on a regular basis. A third party custodian should also handle all your deposits, to ensure checks and balances. An independent custodian can help ensure the safety and security of your assets, and will provide you with a clear, concise statement every month. A duplicate monthly statement is also sent to your advisor. Make sure this is also a legitimate and upstanding business.

Working with a trusted independent RIA can help you realize your financial goals, while allowing you to spend less time worrying about and managing your investments. If you need help finding a financial advisor through the TD Ameritrade AdvisorDirect program (2), visit www.tdameritrade.com.

By ROBERT W. WOOD – Forbes.com

Do You Feel Lucky?  No one wants to be audited.  And yet as a tax lawyer advising clients about tax issues, I’m required by Treasury Department rules to assume every return will be audited.  In truth, there might be only a 2% chance of audit. When I say there’s a 50/50 chance a tax deduction will be upheld, I must assume it will be examined.

Because of these strict standards, it can be awkward to talk about audit risk.  But understandably, no matter how sure you are of your return, you don’t want to be audited.  You want your return to look plain vanilla, and nothing prevents you from trying to make it sail through as long as you fully and fairly complete it.  See 10 Ways To Audit Proof Your Tax Return.

Audit Witchcraft? There are many old wives’ tales about what does and doesn’t trigger an audit, but the latest IRS stats are worth a look.  The IRS has pulled back the shroud on audit rates in its 2010 Data Book, providing important clues about your chances.  The numbers reveal some surprising percentages.

To continue reading go to What’s Your IRS Audit Risk? at Forbes.com.

Where do I go? Where do I look? What do I ask?

Finding qualified, independent financial advice should not be difficult. But it is for many hard-working Americans. With so many people claiming to be  financial planners, financial advisors, financial counselors, wealth managers, how do you know when you’ve found someone who can really help you? The National Association of Personal Financial Advisors (NAPFA), the country’s leading professional association of Fee-Only financial planners, is pleased to provide you with this field guide to assist you in your pursuit for a qualified, independent financial advisor.

The Pursuit of a Financial Advisor Field Guide is set up to help you with every aspect of your quest, including:
• Preparation for the Pursuit
• Equipping Yourself – Knowing What To Ask!
• Selecting Where To Look
• Evaluating Potential Advisors
• Engagement
• Evaluating Your Advisor
• Additional Tools and Resources

Go here to get your copy of Pursuit of a Financial Advisor Field Guide.

Happy hunting for your financial advisor.

Planning allocations between entities and beneficiaries is even more critical with higher tax rates on the horizon.

By Sonja Pippin, Ph.D. – Journal of Accountancy

New tax laws will have a significant impact on the taxation of trusts. If you, or someone you know, is acting as trustee to an irrevocable trust, then you need to pay attention to this article.

Estates and nongrantor trusts must file income tax returns just as individuals do, but with some important differences. For one, their income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries. And because their exemption amounts, tax brackets and related thresholds haven’t been indexed for inflation or modified for tax relief to the extent those for individuals have, they can be subject to higher tax rates at much lower levels of income. With the new Medicare tax on investment income on the highest tax brackets, estates and trusts pay still more taxes on incomes over $11,200, as opposed to $200,000 or $250,000 for individuals.

In this and other ways, the Patient Protection and Affordable Care and the Health Care and Education Reconciliation acts of 2010 (PL 111-148 and PL 111-152, respectively) affect trusts’ and estates’ income taxes and have introduced discrepancies that tax practitioners can review with their clients who administer trusts and estates. This article reviews some strategies for more tax-efficient allocation of income and principal by trusts and estates.

For the complete article, go to Income Tax Accounting for Trusts and Estates in the Journal of Accountancy

Rebalancing Act

In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a different portfolio.

Once you form a portfolio to match your current investment goals and risk tolerance, you should preserve its structural integrity since asset allocation accounts for most of a portfolio’s return.¹ This is a strategic priority, like portfolio design or investment manager selection. To efficiently pursue investment goals, you must manage asset drift.

Rebalancing is the remedy. To rebalance, you sell assets that have risen in value and buy more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making—an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

Challenges and decision factors

In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance.

Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, the benefits must outweigh the costs.

Given these challenges, a practical rebalancing approach will establish asset drift triggering points while leaving enough flexibility to manage costs effectively.

Defining triggering points helps investors decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.
• Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

Rebalancing incurs real costs that can detract from returns. We can help investors define ranges within which investment components can acceptably drift, and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.

No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

Endnotes

¹ Gilbert L. Beebower , Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance ,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Disclosures

Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.

Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty, and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.

Diversification neither assures a profit nor guarantees against loss in a declining market.

A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.

Forbes magazine reports on a collosal failure at Wal-Mart to put their employees first in the administration of their 401(k) plan. Who is the big winner? Merrill Lynch, who else? This is how Wall Street works. I hope this is a wake up call to many Americans who are being fleeced by the likes of Merrill Lynch in their retirement plans. I encourage you to take a good look at your plan, find out how much is being paid from your assets compared to what you could get it for – if employee benefit is on the top of the list rather than broker benefit.

For the whole Forbes story go to Wal-Mart 401(k) Pays Retail

The previous column in this series focused on some theoretical aspects of market efficiency and offered points to help lead investors toward your passive corner. As they begin to march in this direction, however, other questions based on practical, if not emotional, considerations may arise. The following responses may reinforce their conclusion that a passive strategy provides the best odds of success.

Q: If there will be managers who beat the market, who cares if there are no more than would be expected by chance? We only need to pick one!

A: As explained in the previous column, equilibrium accounting presents a dilemma for active managers. We know that for every winner there must be a loser because active management is a zero sum game (before costs) relative to the market. This is due to the adding-up constraint, which infers that market returns must reflect all investors who collectively participate in the market. Therefore, the essence of the active-passive decision is to determine whether one can identify the active management winners in advance.

As I mentioned, there aren’t any more winners in this zero sum game than you would expect by chance, so the real issue is whether you can distinguish luck from skill among the past winners in an attempt to find managers who will win in the future.

There is a large volume of literature on this subject, and the conclusions generally point toward very little persistence in the superior returns of past winners. There may indeed be skillful managers, but the data is too noisy for us to pull them out of the sample that includes a large number who just got lucky. Your assumption should be that ex-ante, the expected alpha (or performance relative to the market return for a given level of risk) of any manager is negative, regardless of past performance.

Here’s another way to think about it. If you find a manager who was in the top quartile in the past, that manager has a 25% chance of being in the top quartile in the future. Unfortunately, so does every other manager, with the exception of those who charge extraordinarily high fees or have extremely high turnover, as research shows that high-cost and high-turnover managers are more likely to persistently underperform the market, net of fees and expenses.

Q: But I just read a report showing how the average manager outperformed in all the prior bear markets! Doesn’t that suggest the zero sum game did not apply in those periods?

A: These types of reports often suffer from two deficiencies. First, they usually fail to adjust for survivorship bias, which would impact the results dramatically. For example, the latest Standard & Poor’s Index versus Active (SPIVA) report indicates that survivorship in the most recent five-year period was 44.9% for Canadian equity funds.¹ If more than half the funds in Canada didn’t survive the last five years, imagine how small the sample of survivors would be today for the 1980-82 bear market. Drawing conclusions from such a small sample of survivors would be like attending a World War II fighter pilot convention and concluding that being a World War II fighter pilot results in longevity because everyone at the convention was over 80 years old. Unfortunately, that conclusion would not account for those who did not survive!

The other problem is the results in these types of reports are often equally weighted rather than asset weighted. Although it is generally instructive to show both, an equally weighted average does not reflect the actual outcome investors experienced. This is analogous to buying ten stocks but putting $91 in one stock and $1 in each of the other nine. An equally weighted return calculation would not fairly reflect the portfolio’s actual performance.

Q: Maybe in aggregate active managers won’t beat the market. But can’t they help protect me on the downside and smooth out the ride?

A: The zero sum game means it is mathematically impossible for active investors to collectively win in a down market, as the adding-up constraint holds regardless of the direction the market takes. As William F. Sharpe states in his article “The Arithmetic of Active Management,” “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”²

It is no coincidence that passive strategies began to attract interest from US institutional investors in the summer of 1975. Many had suffered sharp losses in the 1973-74 bear market, despite employing active managers who claimed to offer capital preservation during difficult markets. The poor performance of actively managed strategies during the recent 2008-09 downturn provides additional evidence that, on average, active managers simply raise costs and do not provide superior performance in bear markets.

Q: An active manager incurs significantly higher costs for things like data sources, model development, research, and company visits. Don’t these added costs justify the higher fees associated with active management?

A: Higher fees cannot be justified because of the higher costs involved with active management unless you apply the logic Patrick Ewing used during the NBA work stoppage. In an interview following a collective bargaining session, he was asked to defend the escalation of player salaries to extraordinary levels, to which he responded, “People got to understand that we make a lot of money, but we spend a lot too!” The question is not are the costs of active management higher to the manager, but are the net benefits of active management higher to the investor? As we’ve discussed, the answer seems to be NO.

Q: ETFs and other passive strategies also charge fees. Wouldn’t these fees guarantee that an investor will underperform the market?

A: All investment strategies have costs, so the gross market return is not achievable for investors. Consequently, costs should be a factor when considering different passive strategies, and just because a strategy is passive doesn’t mean it is cost-effective. However, when you adjust for risk, the net return for the aggregate of all passive portfolios is higher than the net return for the aggregate of all active portfolios by roughly the difference in frictional costs. This is not a theory but a tautology, and it must hold every instant!

So, it is accurate to say that in aggregate passive strategies are guaranteed to underperform the market (even when adjusting for risk) by the amount of their frictional costs. But another way of looking at it is to say that the vast majority of active strategies will underperform by even more. Consequently, the odds are in your favour that the passive strategy beats the active one, even though it is guaranteed to underperform the market.

Q: Passive investing relies on the benefits of diversification. But does diversification even work anymore, given that everything seemed to go down in value at the same time, with passive strategies going along for the ride?

A: Although diversification neither assures a profit nor guarantees against loss in a declining market, it can help eliminate company specific (or unsystematic) risk in a portfolio. However, you cannot diversify away systematic risk, and this is what caused the market decline and drop in value of broadly diversified passive portfolios. Fortunately, systematic (or compensated) risk is the only form of risk you should expect to be rewarded for, and the only way to reduce it is to invest in a portfolio with lower expected returns.

However, contrary to what you may think, diversification has been more important than ever. Company-specific risk has increased significantly recently, and this is risk you can eliminate through diversification. It is also risk that you should not expect a reward for bearing!

When we diversify, we give up the opportunity to concentrate our portfolio in the best-performing investments in return for the assurance of avoiding overexposure to the worst-performing investments. Diversification continued to work during the most recent downturn. Although diversified equity portfolios experienced sizable declines, the losses in many widely held stocks were catastrophic—and in some cases irreversible. In addition, high-quality fixed income securities performed very well during the downturn, illustrating the important role of fixed income as a diversifier in balanced portfolios.

Q: Passive investing is a buy-and-hold approach, but does buy-and-hold really work considering investors didn’t make any money for the last decade if they just bought the whole US equity market and held it?

A: It is true that US equity investors have not been rewarded in the last ten years, but this is the risk you must accept as an equity investor in exchange for higher expected returns relative to less risky alternatives like US Treasury bills. If the risk never materialized, even over long horizons, it would be an arbitrage opportunity and the higher expected returns would not persist.

Investors shouldn’t be happy with the results over this period, but what is the alternative? If the alternative to a buy-and-hold approach is a trading strategy, the results likely would have been worse. Once again, the zero sum game’s adding-up constraint means that the only way to profit from your trading strategy is at someone else’s expense. You may get lucky, but chances are you will simply be adding more risk, higher transaction costs, and higher taxes to your portfolio while increasing uncertainty and broadening the range of possible negative outcomes in the future.

Moreover, if you’re contemplating pursuing stock picking as an alternative to buy-and-hold then you may want to consider Jim Davis’ recent analysis of all US stocks going back to 1926. He concluded that the best-performing stocks each year had a pronounced effect on the overall market return. The compound return on all US stocks from 1926-2008 was 9.4%. If you eliminate the top 10% of performers each year, the compound return drops to only 6%, and if you eliminate the top 25% of performers, your compound return goes down even further to an astonishing -1%.

Simply put, if you excluded the very best performing quartile of stocks each year, you would have lost money investing in equities over a period of more than eighty years! The implications of this finding are daunting for stock pickers, given that when you buy a stock—or continue to hold one you have already bought—there is a 75% chance each year that it will fall outside the universe of winners that accounts for all of the market’s return.

William Bernstein commented on Jim’s finding as follows.

“This may get you thinking: If a small list of securities accounts for the market’s long-term returns, why not avoid all the headaches and losses you’ve suffered recently by carefully choosing these super stocks? Simple: Because a portfolio of ‘carefully chosen’ equities could easily wind up with none of the best-performing stocks in the market—and thus produce flat or negative returns over many years . . . Remember that the point of investing isn’t to aim for the highest possible returns. It’s to make sure you don’t die poor. Yet trying to optimize your performance by seeking out the needles in the haystack is a sure way of becoming, well, poor.”³

Q: Aren’t passive strategies like ETFs best suited for do-it-yourself investors who don’t value expert advice?

A: The premise of passive investing is that no value can be added from stock picking or market timing. Passive investing doesn’t imply there is no value in expert advice. Most fee-based advisors focus on wealth management rather than stock picking or market timing. Wealth management is based on holistic advice revolving around things you can control, such as saving, spending, taxes, costs, risk management, risk budgeting, asset allocation, communication, and reinforcing discipline. The right passive investments fit very nicely in this framework, and the complexity of passive alternatives supports the need for professional advice.

Q: You make some good points, but I don’t fully grasp all of this and I’m not completely convinced. What is the bottom line?

A: Let’s say markets are in fact inefficient, that there are managers who do persist in outperforming, and that you don’t like the idea of indexing. The bottom line is that none of these points would really matter. Here’s why:

• If the market is inefficient, then the aggregate of all investors will still underperform a market rate of return by the amount of frictional costs (fees, trading costs, taxes, etc.). This is due to the adding-up constraint at work in equilibrium accounting.

• If there are superior managers, I have no way to identify them in advance and neither does anyone else.

• If you don’t like the idea of indexing, then let’s invest in passive funds that can address many of the flaws in merely tracking a conventional index.

The only question that matters is whether you, or someone you know, can reliably identify enough superior-performing investments, in advance and after costs, to outperform a market rate of return. The answer is probably NO! So let’s at least put the odds of success in your favor.

Investing is risky enough to begin with. Why add another layer of risk with no expected return?

For the first article in this series go to Active vs Passive: Man vs Market

________________________________________________________________________________________

The comments of Sam Adams and Weston Wellington are gratefully acknowledged.

¹ Standard & Poors, Index versus Active Funds Scorecard for Canadian Funds, June 4, 2009, 5.

² William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.

³ William J. Bernstein, “Are Stocks a Loser’s Bet?” CNNMoney.com, May 9, 2009, http://money.cnn.com/2009/05/09/magazines/moneymag/stock-strategies.moneymag/index.htm (accessed July 15, 2009).

This is intended to discourage people from invading retirement plans early. And, it generally works.

However, there are occasional cases in which a person simply must begin taking funds from their IRA. There is a way to avoid these penalties. It is known as the SEPP or “Substantially Equal Periodic Payments” plan also identified by the tax code as 72(t). These payments must continue until the person is age 59 1/2 or 5 years, whichever is later. If these payments are modified, all of the prior payments become subject to the penalties. You must be very careful about violating the rules if you embark on this plan.

Here is the story about someone who innocently got stung by “modifying” her payments.

In a recent IRS Private Letter Ruling the rigidity of the rules under IRC § 72(t) by which substantially equal periodic payments are exempt from the 10% early withdrawal tax is illustrated. An individual’s non-taxable transfer of a portion of her individual retirement account to another IRA constituted a prohibited “modification” of the payments, which the IRS ruled could not be corrected by reversing the transfer. The error resulted in the distributions she had taken over the prior seven years all being subject to the 10% early withdrawal tax and interest.¹

Transfer of Only a Portion of the IRA Caused a Modification

In 2008, an individual taxpayer submitted a request to the IRS for a private letter ruling (PLR) after learning that her non-taxable transfer earlier that year of a part of her IRA resulted in a prohibited “modification” of the “substantially equal periodic payments” plan she had been taking from that IRA since 2002. The taxpayer had completed the transfer on the advice of a financial advisor who suggested she invest a portion of the IRA in certificates of deposit, which were not available at the current financial institution, but which were available for IRAs at another institution. After opening another IRA at the other institution, the taxpayer transferred a part of her original IRA. Later the same year, the taxpayer consulted with representatives of a third financial institution about the possible transfer of the remaining IRA assets and was informed that the prior transfer constituted a “modification” of her series of substantially equal periodic payments. In later speaking with her financial advisor she was told that the transfer would cause the imposition of the 10% early withdrawal tax, plus interest, on all amounts that had been withdrawn from the IRA since 2002.

Early Distribution Penalty Applies Retroactively

The taxpayer was age 56, and had begun taking substantially equal periodic payments from the IRA six years earlier at age 50, in 2002. IRC 72(t)(1) imposes a 10% tax on early distributions from qualified plans and IRAs. However, the tax is not imposed if the distributions are part of a series of “substantially equal periodic payments” that are made at least annually over the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and beneficiary. But, if the payments are modified (other than by reason of death or disability) before the individual reaches age 59-1/2, or after the individual reaches age 59-1/2 but before the close of the 5-year period beginning with the first payment, then the taxpayer is obligated to pay the 10% early withdrawal tax that would have been imposed on the earlier payments, plus interest.

“Substantially equal periodic payments” are calculated by using the account balance as of the first valuation date selected. Therefore, as the IRS explained in the letter ruling, a modification occurs if there is any (1) addition to the account balance other than gains or losses, (2) nontaxable transfer of a portion of the account balance to another retirement plan or IRA, or (3) rollover of the amount received so that it results in the distribution not being taxable.

Error Cannot Be Corrected by Reversing the Transfer

As a result, despite the fact that the transfer was made on the basis of erroneous advice from her financial advisor, and the taxpayer had proposed to correct the error by transferring the amount back to the original IRA, the IRS ruled that a “modification” had occurred and could not be corrected by undoing the transfer. Since the modification occurred in 2008, before the taxpayer reached age 59-1/2, she was obligated for that year to pay an additional 10 percent early distribution tax on the distributions she had taken from the IRA since 2002, plus interest.

It seems sort of unfair to the taxpayer since it was the result of incorrect professional advice and since she offered to restore the funds to their original position. This does underscore the importance of good advice before taking action in the more esoteric areas of practice. The rules really are quite clear, but not too many people take action under the SEPP provisions of 72(t) and as a consequence even many advisors are not clear on the rules.
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¹.PLR 200925044 (March 23, 2009)