When an individual receives settlement proceeds related to investments held in an IRA account, and wishes to roll over the amount to an IRA, the settlement must be analyzed to determine if it is considered to be a restorative payment. Only a restorative payment can be rolled over to an IRA. The restorative payment serves as replacement funds to replenish the IRA for the losses it suffered.
Restorative payments are those made to restore IRA losses that resulted from breach of fiduciary duty, fraud, or federal or state securities violations. Payments may be court-approved settlements or independent third party arbitration or mediation awards. Note, however, that if the settlement is intended to make up for poor investment performance or general market fluctuations, the amount is not considered a restorative payment.
To qualify for tax-free treatment, the restorative payment must be rolled over within 60 days of receipt. In cases where it’s unclear whether the entire settlement qualifies as a restorative payment, the individual may choose to roll over the entire proceeds within 60 days and immediately begin the process of submitting a private letter ruling request. An IRS ruling obtained in a timely manner would then allow the individual to take a distribution of any excess contribution. The excess portion can be distributed without penalty if the distribution was made by the extended due date for filing Form 1040 for the year of the rollover. If the excess is not distributed by this date, it’s subject to the 6% annual penalty on excess contributions.
In Private Letter Ruling 200852034, the taxpayer established an IRA with an investment company. He gave total control of managing the investments of the IRA to an investment advisor who was instructed to invest the funds based upon a moderate level of risk tolerance. Instead, the advisor aggressively managed the account resulting in losses approximating 50%. The taxpayer alleged that the advisor had actually invested the IRA in some of the most volatile and speculative securities ever created—index-based leveraged mutual funds that were associated with high fees and trading costs, for example. And, as if this weren’t bad enough, after losing close to 50% of the account, the advisor then began using the remaining account for day trading of index funds in a failed attempt to replenish the account’s value.
These events occurred over a five year period. The taxpayer began a securities arbitration proceeding against the advisor resulting in a settlement consisting of compensatory damages of Amount A, punitive damages of Amount B, litigation cost award of Amount C, and attorney fee reimbursement of Amount D. The amount of actual attorney fees and litigation costs exceeded the awards for Amounts C and D. The entire settlement was rolled over into an IRA account and the taxpayer then filed for a ruling regarding the amount of any excess.
In the ruling, the IRS determined there was reasonable risk of breach of fiduciary duty that resulted in the settlement payment. Therefore, a portion of the payment made to restore the losses qualified as a restorative payment (and was therefore a qualified rollover). This determination was made pursuant to a facts and circumstances test set forth in Rev. Rul. 2002-45. Of the total amount, only a portion of Amount A (compensatory damages) was eligible to be rolled over to the IRA account. The IRS held that the portion of the compensatory damage award retained by the attorneys to pay their fees was not eligible to be rolled over. Only the net compensatory damage amount (after subtraction for allocable legal fees) was eligible for rollover. The taxpayer was required to distribute the remaining amount from the IRA in a timely manner to avoid the excise tax on excess IRA contributions. |