IRA Cheats Become Focus on IRS Cop Beat

NEW YORK ( AdviceIQ) -- The word is out that the Internal Revenue Service is less and less lenient regarding individual retirement account mistakes. Potential penalties are large.

Failing to take a required minimum distribution (RMD) from your IRA socks you with a whopping penalty that is 50% of the RMD itself. The penalty for an improper IRA contribution is 6% annually, potentially accumulating for years on end. As a result, you should be more cautious than ever complying with all IRA rules.

A recent article in the Wall Street Journal described how the IRS appears to be cracking down on IRA snafus with increased audits and less leniency in forgiving penalties and interest.

The shift in the IRS's position isn't entirely surprising, given the federal budget deficit. It's far easier politically to raise revenue by simply better enforcing the existing rules on the books, than it is to cut spending or increase taxes. According to the article, the Treasury inspector general for tax administration estimates that the IRS failed to collect as much as $286 million in 2006 and 2007.

IRS Penalties on the Table

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.

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--By Michael Kitces, partner and director of research for Pinnacle Advisory Group, for AdviceIQ

Kitces, MSFS, MTAX, CFP, CLU, ChFC, is a partner and the director of research for Pinnacle, a private wealth management firm located in Columbia, Md., that oversees approximately $1 billion of client assets, and Pinnacle Advisor Solutions, a firm that provides outsourced investment management services for financial advisors. He is the publisher of the e-newsletter The Kitces eport and the blog Nerd's Eye View through his website Follow Kitces on Twitter at @MichaelKitces.

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