Fundamental to every decision we make should be a risk and reward evaluation, but there are times when we don’t really think through the possibilities or simply aren’t aware of them. This is always going to happen, and my solution to this is to attach a level of risk to the underlying instrument.
For example, if you plan to head to the store and buy a 2 litre bottle of Pepsi with a $5 bill, the worst case situation (financially) is attached to the loss of the $5 bill. Whereas if you are in store and are asked to sign up for a credit card in exchange for a free bottle of soda, the instrument changes to the credit card, and the potential for long term debt arises. From the credit card company perspective, this is a great risk reward equation, but a terrible one for the consumer.
In a world where points are apparently hard to come by, people will do whatever they can to earn more. A long term classic has been transferring money between custodians to chase sign up bonuses. It seems ‘risk free’ with the worst case scenario being that you have to pay them some trading fees as you day trade Uber future swaps.
What happens when things go wrong?
Firstly, what could go wrong? If you are transferring stocks/funds/bonds held within a brokerage account you should elect something called ACAT or an old fashioned transfer. Either way is designed to move your positions in situ, retaining basis. If you were to sell everything, wire cash, and then buy again you’d create a tax recognition event, so the transfer option seems smart.
However, if you do have a capital gain on a position transfer you are basically tossing around a financial grenade, and if you happen to pass that grenade to someone not too sharp, it could go very wrong.
Account transfer teams have the ability (even if they don’t have the authority) to sell your funds on your behalf during the transfer between two custodians. If they do this, they don’t always mention it, it just happens.
How to minimize the risk
- Qualified accounts (IRAs etc) have inherent tax protection, so if you (or some stranger) should sell a largely appreciated position, no gain is realized. Therefore, if you want to play the account transfer game IRAs are safer in this regard, though they may have their own risks, such as an incorrect transfer where you gain custody of the account and have to pay an early withdrawal penalty of 10% on top of the taxes owed. You can minimise risk by using a qualified account, doing this no more than once per year, and ensuring the funds go custodian to custodian directly. If you see a check, get it to them within 60 days (actually do it the day you see it!). I’m not advising you use these accounts to earn points, just explaining the difference from a capital gain perspective.
- Don’t transfer funky funds. Not all custodians will handle all funds, if the account transfer teams encounter a fund that they cannot take custody of they are more likely to liquidate it. While they should ask, they may not. Funky funds can be identified as those that are very old (no longer issued) or issued by certain employers as retirement funds or other bonuses.
- Don’t trust regular funds too much.. despite the above, I’ve encountered a situation where a huge Vanguard fund was sold in a taxable account, sometimes you just get unlucky with the account transfer team.
What happens when it goes wrong
If you check your new account and there is a larger cash position than you had pre-transfer, it is likely that a sale occurred. Check to make sure everything is intact. If a sale has occurred you need to contact the inbound firm to ask them to rectify the transaction. In the financial world this is called ‘unwinding’. The concept is that they will work with the contra firm (original firm) to resolve the mistake. They should pay you any missed dividends and restore the account to the same position as though the trade never happened. However, it is still possible that the old firm will issue you a 1099 at year end that states a taxable sale occurred, with a capital gain to report on your taxes.
It is very important to catch the unwinding of the sale promptly, as there have been cases where duration has been a consideration as to whether the unwinding is legitimate or not.
In terms of tax preparation, if this has happened to you I would suggest that you bring in a CPA or EA that can help manage this, as the brokerage firm might be telling the IRS that a capital gain has occurred you’ll need someone who knows how to explain that it didn’t happen. This will likely involve form 8275 and citation of revenue procedures and statutes.
There aren’t many free lunches, and when you reach further for silly things like points or miles or free Pepsi remember that the more things you bring into play as a tool, the more things can go wrong. When you are playing with high stakes, such as taxes, make sure that you watch everything closely and get them resolved quickly. As much as you think this won’t happen, it does, and when it does don’t expect anyone to catch it for you, or fix it for you.