Consider the first, failing to take an RMD. Thus, for example, a person with a $1 million IRA reaches age 70½ and doesn't realize it is time to take an RMD. At that point, his life expectancy is 27.4 more years, according to the Uniform Distribution Table. So his first RMD is $36,496. By failing to take that money out of his account, he faces a $18,248 penalty. Plus, he still needs to take the RMD of $36,496 itself, which is also subject to state and federal taxation. In the past, taxpayers could request a waiver of the penalty by correcting the error immediately, and filing Form 5329. The waiver was commonly granted. Now, however, it's unclear whether the IRS is likely to be as kind in letting people off the hook. The second IRA penalty, the 6% excess contribution penalty tax, is arguably the more common. That's because it can apply in so many different circumstances. For instance, an individual who contributes to a Roth IRA but is over the income limit must pay the penalty. So is someone who improperly completes an IRA rollover, say by shifting the money from one institution to another. You have 60 days to do that. If the rollover occurs after the 60-day window, it is technically an excess contribution, and the entire rollover is subject to the penalty. And notably, every year that an excess contribution remains in an account, it is hit with a new excess contribution penalty. How Can the IRS Catch Wrongdoers?
In the more distant past, it was relatively difficult for the IRS to find wrongdoers, even if IRA mistakes were made. However, since 2004, IRA custodians are required to provide a calculation of the distributions to IRA owners, and also to the IRS on Form 5498. Now, it's quite easy for the IRS to determine whether people took RMDs properly. The IRS simply waits and sees if the custodian issues a Form 1099-R for the taxpayer, reporting an IRA distribution. If the total of the 1099-Rs don't at least add up to the RMD from Form 5498, and are not reported as income on the individual's own tax return, clearly an RMD was missed. Then a penalty can be levied. For excess contributions, it's harder for the IRS to catch mistakes. IRA custodians are also required to issue a Form 1099-R for a distribution (including a rollover), and the receiving IRA custodian must issue a Form 5498 to report any contribution to an IRA (whether an annual contribution or a rollover contribution). But the IRS currently does not require the dates of the distributions and contributions. Consequently, the IRS may know if contributions or rollovers occurred, but it has to audit further to determine whether they were done in a timely manner, or were otherwise permissible. Nonetheless, some basic errors can be caught on this basis alone. For instance, if a Form 5498 reports a Roth IRA contribution, and the individual's tax return indicates that income was too high for a contribution. Notably, the rising IRS aggression toward collecting various IRA penalties also raises the risks of various popular Roth conversion strategies, such as the so-called "backdoor Roth IRA contribution" or trying to split pre-tax and after-tax 401(k) distributions to convert the after-tax amount and roll over the pre-tax amount. More from AdviceIQ