Individual Retirement Arrangements (IRAs) hold trillions of dollars. These dollars are sheltered from taxes, for the most part until the owners decide to take distributions. The IRS discovered, however, that IRAs are a rich goldmine of unpaid taxes and penalties, because taxpayers are not following all the rules. Recently the IRS studied a sample of IRA owners over age 70½ and found a high percentage of those with large IRAs were not taking their required minimum distributions (RMDs).
Here’s what you need to know to avoid problems with the IRS.
Congress suspended RMDs for 2009 so IRA owners who didn’t need the distributions could let their balances recover from the investment declines of 2008. But the suspension was for only one year, and there’s no indication Congress plans to suspend RMDs retroactively for 2010 or for any future year.
The IRS receives up to two reports from IRA custodians for each IRA with an owner over age 70½. These reports can help the IRS determine if RMDs are being taken. One report is Form 1099-R that reports the amount of distributions for the year. The IRA owner also receives a copy of this form.
The other report is Form 5498. This provides the IRS with basic information about the owner of each IRA: Name, address, Social Security number, IRA balance, and whether an RMD was required for the year.
In a recent study the IRS compared the two forms for a sample of taxpayers and found a high percentage whose 5498 indicated an RMD was required but did not also have a 1099-R filed. The lack of a 1099-R indicated the IRA owner failed to take an RMD. Further investigation revealed that a number of the IRA owners hadn’t broken the rules. For example:
? In some cases the IRA custodian was wrong. Either a 1099-R was not filed when it should have been or the taxpayer was not required to take an RMD though the 5498 said he was.
? Some taxpayers turned 70½ during the year the form covered but postponed their RMDs until the following April 1, which they were allowed to do.
? Other taxpayers died during the year, and their beneficiaries took the RMDs as required.
? In some cases the owners died during the year, and the IRS couldn’t locate the beneficiaries. It couldn’t verify if the beneficiaries took the RMDs.
Subtracting all those cases leaves 43% of the group that the IRS found did not take their RMDs and did not qualify for exceptions. They owed the penalty of 50% of the RMD. That’s a sizeable percentage of the people who are required to take RMDs and failed to, so the IRS plans to step up enforcement in this area.
Detailed audits on this issue aren’t practical, unless the IRS has other reasons to audit the taxpayer. What’s more likely is the IRS soon will update the Form 5498 so IRA custodians are required to report more information. This would make it easier for the IRS’s computers to determine if an IRA owner over age 70½ took an RMD.
In addition to the steps discussed in the previous article, here’s what you need to do to avoid penalties and audits and also reduce taxes.
Leave good records. Your executor and beneficiary need to be able to locate records of your IRAs easily so they can tell the amounts in the accounts and whether you took RMDs for the year.
Report yourself. When you didn’t take the full RMD for a year, take it as soon as possible and report it on Form 5329. There are some excuses for a late RMD listed on the form. If you think you qualify, say so and attach a statement to the form. Otherwise, pay the penalty.
Know the rules. Even when you manage your IRAs properly, there still are situations when the IRS may raise questions.
For example, as discussed previously in this visit, when you have multiple IRAs you compute one aggregate RMD for all the IRAs. Then, you decide how to take that RMD from the accounts. You can take pro rata amounts from each account. You also can take it all from one IRA, or take portions from each IRA in whatever ratios you prefer. If the IRS doesn’t do proper matching of all your IRAs, you may have to show them you took the right amount.
The IRS also is looking into other IRA issues. Early distributions before age 59½ are reported on Form 1099-R, so it is easy for the IRS to track these and impose the 10% penalty.
The IRS also looks at rollovers. When you don’t complete a rollover within 60 days, it is treated as a distribution. The IRS used to be fairly lenient and waive the penalty, but it appears to be less understanding of mistakes and late rollovers. You can avoid most problems by having rollovers made directly from one IRA custodian to another.
Contribution limits confuse many people. The limits change, and there is a higher limit for those 50 and over. You can’t contribute to a traditional IRA after age 70½ (but can contribute to a Roth IRA at any time). The IRS believes people are contributing too much to IRAs and is looking to track down the excess contributions.
IRA investments also draw the IRS’s attention. It is especially looking for situations when IRAs are used to invest in small businesses or in prohibited assets. There are ways to do this right and ways that will disqualify your entire IRA, triggering income taxes and penalties. You can read details about IRA prohibited investments and transactions in my report, IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments. It is available on our web site under the Bob’s Library tab.
Be sure you know the rules and have good tax advice before using your IRA to invest in a small business or any other unconventional investment.
RW December 2010.