The IRS and Your Retirement Income

Retirees are a major source of the “tax gap,” according to the IRS. The tax gap is the difference between what Americans actually pay in income taxes and what they’re supposed to pay if they followed the law exactly. The IRS says about $4.2 billion of the tax gap is attributable to underpaid taxes on retirement income. The tax gap generally is the fault of Congress and the IRS for making the rules too complicated. Sophisticated lawyers and CPAs write rules that are supposed to be followed by regular people who rarely even balance their checking accounts and of course struggle with the cognitive decline that often accompanies aging. The Inspector General of the Department of Treasury recently identified ways the IRS could reduce the tax gap, though they don’t include simplifying the law.

The IRS’s main tool for ensuring retirement income is properly reported is to have payers of retirement income (IRA sponsors, annuity insurers, pension funds) issue Form 1099-R identifying the gross amount paid to people during the year. When people don’t report the gross amount, they receive a letter from the IRS saying they owe additional taxes.

But the form is confusing and incomplete. Many forms say the taxable amount of the distribution isn’t determined. People who made after-tax contributions to IRAs, annuities, and employer pensions get to exclude part of that amount from each distribution until the contributions are recovered. That isn’t accounted for on the forms and is up to the taxpayer to compute.

The IRS conceded in its response to TIGTA that the rules around reporting taxable retirement income represent one of the more complex areas of the tax law many individuals face, and agreed that it would revise the instructions for Form 1099-R to make it clear that taxpayers are responsible for determining the taxable amount of their retirement income. And the IRS plans to study the feasibility of capturing additional information on a form to be filed with the tax return.

The IRS dismissed another TIGTA recommendation to include dates of retirement income distributions on the 1099-R as largely unworkable. (This would catch folks who, instead of doing direct institution-to-institution transfers, cash out their retirement money and miss the 60-day rollover period for moving it back into a qualified plan).