Beneficiary IRAs and Defining a 'Business'

This week, Gail fields reader questions on beneficiary IRA accounts and tax issues for people with unusual occupations.

Dear Gail,

My two siblings and I were beneficiaries of my dad's IRA account. The money from his account have been distributed to three "Beneficiary" IRA accounts -- one for each of us -- and we are now withdrawing the money annually.

Unfortunately, the institution we are dealing with is frequently sending our statements to erroneous addresses and distributing amounts to us that were not requested. I would like very much to change the institution that my beneficiary IRA is currently being held at.

I seem to remember that it is not possible to roll over a beneficiary IRA, but can't remember if this is a policy of the individual institution or of the federal government. Is there any information you can provide in this regard?

Thank you,

Craig

Dear Craig,

You are correct: a non-spouse who inherits an IRA cannot "roll it over" into his own name. Instead, the original owner's name remains on the account, with the beneficiary on the account receiving the distributions.

However, you don't need a rollover, you need a new IRA custodian! And as the beneficiary of an inherited IRA, you have every right to change this. In fact, given the mess your current custodian is making of things, you should do this as quickly as possible.

But there's a right and a wrong way to go about it. The best and cleanest approach is to first decide who you want to use as your new custodian. Every mutual fund family, brokerage firm and bank offers IRA accounts. Once you've selected one such company to serve as your new custodian, call them and explain what you want to do. They should send you the necessary paperwork needed for a "trustee-to-trustee" transfer. This is a direct transfer of your dad's IRA from the old to the new custodian.

(Note: It's important that you do not withdraw the full IRA balance and move it to the new account yourself. You should not actually take possession of the money! Make sure it travels directly from one custodian to the other.)

The beauty is, once you turn in the paperwork for a "trustee-to-trustee" transfer, you don't have to do a thing more. Your new custodian arranges for the funds to be transferred over and invests them according to your directions. The account will still be titled as a "beneficiary" IRA, with your dad listed as the owner and you listed as the beneficiary. The difference is, hopefully, you'll eliminate the foul-ups you're currently experiencing.

If the current custodian of your dad's IRA argues with you about this, refer them to IRS Private Letter Ruling 9250040.

Best wishes,

Gail

Hi, Gail,

I'm a day trader (yes, there are still some of us around). I consider this my full-time job. The only income I receive is generated by my trades.

I'd like to reduce my taxable income by setting up a retirement plan for myself -- either an IRA or a SEP. Is there any problem with me doing this?

Thanks,

Bruce

Dear Bruce,

Unfortunately, this is not possible. You are only eligible to contribute to a retirement plan, including an IRA, if you have "compensation." Section 415 of the tax code says this includes wages, salaries, and fees for professional services. According to the Internal Revenue Service, profits generated by your trading are considered "capital gains" and not "compensation," so they cannot be used to contribute to any type of retirement plan.

You also need to be aware of some other potential issues that can trip you up tax-wise.

First and foremost, although you consider yourself a full-time trader, your activities might not qualify as a "business" in the eyes of the IRS. This matters because it affects how you report your profits and expenses.

If your trading constitutes a bona fide "business," then your expenses (such as renting the terminal you use) are fully deductible and you would list them on Schedule C, "Profit or Loss from a Business."

On the other hand, if you are just an "investor" who trades frequently, your trading expenses would come under the heading of "Miscellaneous Itemized Expenses" on Schedule A. In that case, your deduction is limited to the extent that your total Itemized Expenses exceed 2% of your adjusted gross income.

While the IRS describes a "business" as an activity that is generally "carried on for a livelihood or in good faith to make a profit," there is no clear definition of when a "hobby" crosses the line and becomes a "business." This is something that has been left for the courts to hammer out.

However, on its Web site, the IRS gives some factors which would lend support to your contention that your trading is, in fact, a business:

"You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.

"Your activity must be substantial.

"You must carry on the activity with continuity and regularity."

In other words, how serious are you above this? How much time do you spend trading? Do you put in time daily? For how many hours? How much of your income is derived from your trading? How big are your trades? In IRS-speak, the "facts and circumstances" of your particular case will determine which category you fall into.

Margin interest is another issue. If your trading activity constitutes a business, then money you borrow to make investments is fully deductible as a business expense in the year it is incurred. However, in the case of an investor, the amount of interest you can deduct is limited to no more than the net income your investments generated that year. Any excess would be carried over to the next tax year.

Keep in mind, whether you are a "business " or not, your gains and losses are filed on Schedule D. As a day trader, by definition, you are buying and selling securities on a short-term basis. So your all of your gains will be taxed at ordinary income tax rates as opposed to the lower, long-term capital gains rate.

Every individual's situation is different, which is why I strongly urge you to find a competent tax preparer to help you navigate these regulations. And be sure to get a copy of IRS Publication 550, which has a section for those whose trading qualifies as a "business." It's entitled "Special rules for Traders in Securities." You can download it from the IRS website.

Hope this helps,

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.