IRA Valutions: Who Cares What It's Worth?

Not all IRAs are created equal (when it comes to providing an annual valuation, at least).

Consider the case of “Berks vs Commissioner of Internal Revenue.” In the case, Bernard and Claire Berks invested in notes with their IRAs but the borrowers either defaulted or their collateral did not adequately secure the debt. This resulted in the notes being worth zero. The IRA provider, over a period of several years, requested that the Berks provide an annual valuation. The Berks referred these queries to the investment provider who, allegedly, called the provider and told them that “the notes are worth zero.” No documentation supporting this assertion was provided. The Berks requested that the assets be valued at zero and that the provider terminate their accounts. In accordance with the provider’s policy, the assets were distributed from the IRA holder’s account to the IRA holder at the last recorded book value of the asset. In other words, the IRA holder received a 1099-R (form for reporting distributions from pension plans) for the full amount of the account using the original face value of the notes.

The Berks took the case to tax court challenging the valuation of the IRA at the time of distribution. The IRS did not see this situation the same way as the Berks did.  Not only would the IRS not accept the opinion of the Berks that the IRA was worth zero, they penalized them 20 percent of the account value for their “negligence” in failing to make a reasonable attempt to comply with tax laws, maintain adequate books and records or to substantiate items properly. They were also cited with the intentional “disregard” for rules and regulations. 

As is usual in tax cases, the burden of proof falls on the taxpayer. The Berks’ tax return claimed the IRA distributions were not taxable and therefore paid no taxes on the reported distribution. They blamed the preparer for this “oversight.” They blamed the IRA Provider for distributing the account at full value. In short, they took no responsibility for their account or their tax preparation and the court was not sympathetic.  In fact, the court found that these arguments actually proved the Berks’ negligence.

The case brings up a greater issue about the importance of valuations.

IRA holders whose accounts have alternative assets in them receive a request from their IRA providers every year to provide fair market value for their IRA’s assets. For most IRA holders, these annual valuations are of little importance because their IRAs are invested in publicly traded securities and their IRA providers will often prepare valuations for their clients at a fee. For reference, about 97 percent of IRAs are invested in publicly traded securities.

For the $126 billion invested in self-directed IRAs (SDIRA) however, valuations matter a great deal. The account holder, not the provider, is responsible for providing valuations every year on their assets.

This issue of determining fair market values for hard-to-value assets in SDIRAs has become a focal point for the IRS. The IRS is now paying attention to the fact that with many SDIRA assets, there is a wealth of taxes to either be reaped or avoided. 

So the Berks case offers several learning points. First, provide an annual valuation, with documentation, when the IRA provider requests it.  If the asset is worth zero, provide proof that the asset is worth zero. For those with publically traded IRA investments, much of the work is done for them by the IRA investment provider, usually at a fee (we don’t charge a valuation fee at New Direction IRA.)  SDIRAs give IRA holders entrance to every investment allowed by law, but the account holder must find and manage the investment and provide the value annually.  Those are the rules. With SDIRAs, investors receive unlimited possibilities but they are also expected to know and understand the rules.   

The 5-year rule for Roth IRA withdrawals

If you’re one of many investors contributing to a Roth IRA or considering a Roth Conversion for an existing pre-tax retirement account, it’s important to understand exactly how the “Five Year Rule” works. Below is a short explanation of how the rule affects your IRA distributions.

What is the Five Year Roth Rule?

The five year Roth rule refers to a five year period that restricts tax-free distributions on the earnings/gains in a Roth IRA and distributions of converted funds in a Roth IRA. If a Roth IRA achieves gains in addition the contribution amount(s), distributions of those gains before the five year waiting period will be taxable. Similarly, funds that are converted from a “pre-tax” retirement plan to a Roth IRA must wait five years in order to be distributed tax-free. The five year period begins when an IRA holder opens a Roth IRA and begins making contributions OR when a new Roth Conversion is performed. In either event, the actual effective date of the five year Roth rule is always backdated to January 1 of the tax year the event takes place. This can be important because if you time things right, your wait time can actually be reduced by more than 20%. Let’s take a look at some math below to get a clearer understanding.

How is the Five Year Roth Rule Calculated?

New Roth IRA Example: If I start a Roth IRA in April, 2012 (remember to backdate) and begin making annual contributions beginning in the tax year of 2011, my five year time clock will have ended on January 1, 2016. Notice that my effective wait time was less than four years, not five. My wait period begins January 1, 2011, not April, 2012.

Traditional to Roth Conversion Example: If I have an existing Traditional IRA , it’s possible for me to perform a Roth conversion. To perform this process, I pay tax on the amount being converted in order to change my retirement funds from “pre-tax” to “post-tax”. I claim the converted amount on my tax return for the tax year in which I perform the conversion. Once I start this process, the five year rule begins. Just like before, the later in the year I perform my conversion, the more my five year rule becomes a four year wait.
It’s important to note that I must perform my conversion before December 31st or the tax year will effective change. For example, if I’d like my conversion to represent the tax year of 2012, I must complete my 2012 conversion before December 31st, 2012. Conversions made between January 1 – April 15th cannot be backdated to represent conversions in the prior year even though filing deadlines take place in April.

How does the Five Year Roth Rule affect my distributions?

As I mentioned above, the five year rule dictates that distributions, over and above the amount contributed and/or the amount converted, that are taken prior to the five year wait period after the establishment/conversion of the account are not tax-free. See the examples below for a comparison of scenarios.

John, at 57 years of age, makes a maximum contribution of $6000 to his Roth IRA on April 15, 2007 for the tax year of 2006. On January 1st, 2011, John decided to withdraw $8000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principle contribution and $2,000 is profitable earnings. 
Results: Since John is now over the age of 59.5 and his five year rule has expired (Jan 1, 2006 – Jan 1, 2011), the entire distribution is qualified for a tax-free distribution and isn’t included as taxable-income. In the example above, John made a profit of $2,000 over a period of almost four years but because his first contribution in the Roth IRA was dated back to January 1, 2006, his wait for tax-free distributions was considerably shorter than 5 years.

**Note that he was over the required age of 59.5 for tax-free distributions as well.

Now let’s look at the same example if John takes his distribution after only 3 years of participating in a Roth IRA:

John, at 57 years of age, makes a maximum contribution of $6000 to his Roth IRA on April 15, 2007 for the tax year of 2006. On January 1st, 2009, John decided to withdraw $8000 from his Roth IRA. Of the $8,000 that John withdraws, $6,000 is principle contribution and $2,000 is earnings. Even though John is now over the age of 59.5, his distribution on the earnings is being taken out of the account before the five year rule expires. $2,000 of his distribution must be claimed as taxable income on his tax return.
Results: After age 59 1/2 and once the five-tax-year holding period is met, any distribution from the Roth IRA will be considered a qualified distribution and be tax-free. Remember that each conversion from a pre-tax IRA will start its own individual five year waiting period. You may consider keeping any conversions and/or contribution accounts separated in different Roth IRAs for organization purposes.