GreenTraderTax & GreenTraderFunds - Message Board: IRS Denial of Tax-Deferral Benefits of IRA Account

Here is an answer from another question that also applies here. Thanks.

Many readers have asked us more about the 25% rule stated above. It is from a Department of Labor ruling about “plan diversification” applicable only to ERISA covered retirement plans. It is not part of IRS code or rulings.

This 25% rule is intended to prevent companies from investing too much of their company-wide retirement plan assets into their own company stock. Think of Enron. This rule is part of an overall “fiduciary duty” to diversify investments, and manage risk of losses.

Most traders will say, ‘wait I don’t have any employees and why should this ERISA rule apply to me?”

First note that not all retirement plans are covered by ERISA. Individual retirement accounts, including traditional IRAs, Roth IRAs, Rollover IRAs and education IRAs are not ERISA covered plans; and therefore IRAs are not subject to this 25% plan diversification rule. So you can trade your IRA as much as your broker allows and you are not subject to any ERISA rules; only tax rules (see below).

Our current research shows that SEP IRAs and Mini 401 plans set up on the individual-level (with no employees) are not covered by ERISA; whereas Mini 401K plans set up on the company-level are ERISA covered plans. ERISA plans include all company-level plans including but not limited to 401k plans, traditional retirement plans and other qualified retirement plans.

Check back on our retirement plan resource page soon for much more information on this subject. http://www.greencompany.com/Traders/TraderRetirement.shtml. Plus I am writing about this subject for my February column in Active Trader magazine.

If you trade an ERISA plan that only includes yourself (no employees) you may think ‘what’s the risk if no employees can sue me for ERISA violations?” You should also consider that your spouse’s attorney can allege ERISA violations during a divorce lawsuit. A spouse may be entitled to half or another portion of your ERISA retirement plan assets.

Our attorney specializing in retirement plan tax and ERISA issues has suggested in the past that traders only actively trade (with risk) 25% of their ERISA plan assets and should diversify the remaining 75% outside of the active stock trading arena; to conform to the DOL 25% plan diversification rule. For the other 75%, she recommended interest-rate and other types of non-stock investments. She cited some DOL cases which raised this argument in litigation. She also cited ERISA case law which supports the following statement, “a high concentration of plan investments in stocks was prudent for a fiduciary and not an ERISA violation.”

Our CPAs and other tax attorney have a more favorable current interpretation of the 25% rule. We think each case is different and the 25% rule needs to be applied on a case-by-case basis.

Consider the following example of trading in an ERISA plan. A business trader actively trades 10 stocks on a daily basis and he does not keep any positions overnight (day trading) The trader hedges his positions and monitors risk very closely, using stops and other methods. This trader is diversified and notwithstanding the perceived risk of day trading, this trader is consistently profitable.
Unlike the spirit of the 25% plan diversification rule, this trader is not buying and holding only one stock at great market risk without any hedge. An argument can be made that this ERISA plan trading activity is not in violation of ERISA rules.

Now consider the reverse example. A trader actively trades stocks in a very risky manner; no stop losses, no hedging, no risk management and some huge overnight positions. The trader is consistently losing large amounts of money. An argument can be made that this trader violated ERISA rules by not diversifying out of risky swing and day trading.

How to apply the plan diversification rules to ERISA plans for traders is an open issue and not fully defined in case law. So proceed at your own risk. This may account for the fact that brokers offer widely-varying policies on the volume of trading they allow in retirement plan accounts. Some brokers charge higher commissions and restrict trading even in non-ERISA accounts. We are doing a survey and will have this information available on our site soon. Check our retirement page.

Bottom line. If you want to actively trade more then 25% of your ERISA plan assets, you should consult with our firm first.

ERISA stands for the Employee Retirement Income Security Act of 1974. ERISA is responsible to protect employees’ retirement assets administered by companies. To learn more about ERISA click the following links. http://www.dol.gov/ebsa/aboutebsa/history.html and http://www.benefitslink.com/erisa/crossreference_short.shtml

IRS rules - All traders need to also know about IRS rules that effect retirement plans. If you take money out of your plan before retirement age, generally it’s taxable as ordinary income plus you owe a 10% excise tax, unless you meet some exceptions.

The IRS also does not allow “self-dealing” in any manner between your retirement plan assets and yourself. Self-dealing is a “prohibited transaction.” The initial tax on a prohibited transaction is 15%. This means your retirement plan can’t pay you a management or administration fee for managing the money in the retirement plan. You still need an entity to create earned income to drive retirement plan deductions.

We have lots more coming soon on this subject. So stay tuned.

--------------------
Robert A. Green, CPA & CEO
GreenTraderTax.com

Post Extras: