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Ask Ed Slott: Do IRAs Need to Be in a Fee-Based Wrap?
Thursday, February 14, 2013
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My financial advisor told me I was going to have to put money in my IRA in their fee-based account.

He said the department of labor was requiring all IRAs to be in fee-based or wrap accounts?

That doesn't seem right to me. Can you help?

The Department of Labor does not require IRAs to be in a fee-based account, including wrap fees. Wrap fees are fees for investment services where the fee is a percentage of money under management. There are many financial institutions that do not charge fees for IRAs or that charge minimal fees. You need to balance the fee against the level of services that are provided for that fee. It is very easy to make a costly mistake with IRA funds. Sometimes you cannot afford free.

When is an employee age 70.5 required to make an RMD from a 401(k)? The employee also has traditional IRA's.

In a 401(k), you must begin taking RMDs (required minimum distributions) for the year you turn age 70˝. However, if you are still working and are not a 5% owner, distributions may be delayed until you are no longer working, if the plan allows this. This rule applies to all 401(k)s, including Roth 401(k)s.

For IRAs, you must begin taking RMDs for the year you turn age 70 ˝, regardless of whether you’re still working. This rule applies to traditional, SEP and SIMPLE IRAs. Under no circumstances can you take a plan RMD from an IRA or an IRA RMD from a plan.

I am 73 years old and retired in March 2012. My pension consists of two components, money I had contributed through the years and money the company contributed through their defined benefit plan. Upon retirement, I was given several choices as to how I wanted to take my pension distribution. I chose a lump sum to me with the money I had contributed (some of which was contributed after taxes). The money was sent to my rollover provider to be placed into my pre-existing rollover IRA. The company component of my pension is being distributed to me in monthly pension checks.  I was notified in January 2013 that due a miscalculation by the company the amount given me as a lump sum for rollover exceeded the amount of a provision of the Internal Revenue Code of 1986, which only allows a certain percentage of my accrued benefit to be allotted for IRA rollover. What had been given to me exceeded that percentage. I was told that anything over that percentage was considered a “prohibited payment” and needed to be removed from the rollover IRA.  It was suggested that I contact my IRA provider to have the excess removed.  When I do this, the money ($7500) will be returned to me (as it is money I contributed), and it and its earnings for the past 10 months will become a taxable event. I believe the company should accept responsibility for its error and cover the tax expenses I will incur as a result of this error. Is this asking too much?  Do I have any other options for this money other that a taxable event?  Thanks for any suggestions or enlightenment you can provide on this situation.

The information you have provided is not specific enough for us to be able to definitively give you an answer. Whenever an overpayment occurs in a distribution from a plan, that amount is not eligible to be rolled over. In this case, the $7,500 becomes a regular contribution in your IRA and thus is now an excess contribution because you’re past age 70 ˝ and not allowed to make an IRA contribution. In some cases, your ex-employer can request that you repay that amount, plus interest, to the plan.

The deadline for removing an excess contribution is October 15 of the year following the year of the contribution.  You must inform the IRA custodian that you are removing an excess contribution and follow their procedures to correct the excess. When an excess contribution is not timely removed, it becomes subject to a penalty of 6% per year for every year that it remains in the IRA.

Ideally, you should also tell your CPA so he or she can properly address the excess IRA contribution and correction on your tax return.

(1) Comment
As to the Dept. of Labor and IRA accounts, under the Internal Revenue Code issue: First, section 4975(e)(3) of the Internal Revenue Code of 1986, as amended (Code) provides a similar definition of the term fiduciary for purposes of Code section 4975 (IRAs). However, in 1975, shortly after ERISA was enacted, the Department issued a regulation, at 29 CFR 2510.3-21(c), that defines the circumstances under which a person renders ``investment advice'' to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA. The Department of Treasury issued a virtually identical regulation, at 26 CFR 54.4975-9(c), that interprets Code section 4975(e)(3). 40 FR 50840 (Oct. 31, 1975). Under section 102 of Reorganization Plan No. 4 of 1978, 5 U.S.C. App. 1 (1996), the authority of the Secretary of the Treasury to interpret section 4975 of the Code has been transferred, with certain exceptions not here relevant, to the Secretary of Labor.

Hence, when the DOL/EBSA, as is expected later this year, issues a re-proposal of its "definition of fiduciary" regulation, in essence the broad exemptions previously provided disappear, and virtually any provider of personalized investment advice to a plan sponsor or plan participant would be a "fiduciary" and subject to ERISA's strict "sole interests" fiduciary standard and its prohibited transaction rules.

Does this means commissions are outlawed? Not necessarily. The fiduciary standard, whether under ERISA or under the Advisors Act or state common law, does not outlaw the receipt of commission-based compensation. However, the receipt of variable compensation (i.e, if commissions vary depending upon product recommendation) is problematic.

Nor are 12b-1 fees likely to be outlawed by EBSA, although some pundits have stated otherwise. However, 12b-1 fees are already under scrutiny by the SEC (although no action is likely soon). In addition, some concerns exist that, since 12b-1 fees cannot typically be negotiated (beyond various share classes, such as R-1, R-2, etc. in the retirement plan context), the Sherman Antitrust Act may apply and the practice of 12b-1 fees, especially as to retail investors, may be an unlawful fixing of prices and an unlawful restraint of trade.

There is likely to be an exemption granted to the prohibited transaction rules for brokerage firms who receive brokerage commissions for doing trading for funds. Whether the exemption will cover higher brokerage commissions paid in the nature of soft dollars is unknown.

Also, the receipt of "payment for shelf space" by a brokerage firm is very problematic under the ERISA standard.

I suspect that mutual funds and brokerage firms will need to change their business practices. A good approach would be to only have one method of compensation, with no other forms of compensation provided by the fund to the brokerage firm / registered representative. This could be commissions, or could be 12b-1 fees (if not otherwise outlawed), or could be AUM-based compensation paid by the plan participants (and deducted from account balances), or could be even flat fees paid by the plan sponsor (and/or deducted from account balances).

In any event, I believe some of the brokerage firm / mutual fund arrangements must change, such as payment for shelf space and soft dollar compensation - and any arrangement in which a fund is granted "preference" (in return for some form of compensation). Payment of "educaitonal" or "marketing" expenses by fund companies would likewise be outlawed under ERISA's prohibited transaction rules.

We will have to see what EBSA comes up with. And the final rule, if ever adopted, would not likely be effective until 2014 (or later). So, keep your eyes peeled, and be ready to change certain business practices and compensation methods if necessary. Hope this helps.

Posted by Ron R | Friday, February 15 2013 at 2:48PM ET
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