Waiving the Penalty for RMD Mistakes

The IRS likes to catch people who made mistakes with the required minimum distributions (RMDs) from their retirement plans. It’s no wonder. The penalty is a steep 50% of any amount that was supposed to be distributed but wasn’t.

Owners of traditional IRAs and other qualified retirement accounts must begin minimum annual distributions after age 70½. We discussed the details of these rules in the past, with the most recent discussion being in the February 2017 issue.

A few years ago, the IRS noticed that the RMD rules were complicated, and many people were making mistakes. It decided to crack down by changing its audit formulas to identify tax returns with potential RMD mistakes so it could assess the penalties. (The tax code calls the penalty an “excess accumulations tax.”)

Many people don’t know the IRS can waive the penalty, and fewer know how to ask for the penalty to be waived. But there’s a process in place that’s inexpensive and relatively easy to use.

It usually is best to request the penalty waiver on your initiative instead of waiting for the IRS to notify you of a mistake. So, if you have doubts about how you calculated or took RMDs in the past, check them now. Or have a tax professional review them. Don’t wait for the IRS to find mistakes.

The penalty can be waived when the distribution shortfall was “due to reasonable error” and “reasonable steps are being taken to remedy the shortfall.”

Unlike many requests to the IRS, you don’t have to file a private letter ruling request to ask for a waiver of the RMD penalty. That’s good, because the private letter ruling process is a formal one that often requires the taxpayer to hire a tax attorney and pay a filing fee. The process for the RMD penalty waiver is less formal, and many taxpayers can file it without the help of a tax professional.

The downside of the less-formal process is there is no public record of the requests and how the IRS responded to them. Also, the IRS regulations don’t list what it considers reasonable cause. So, it’s hard to tell which waiver requests the IRS has or will grant.

Tax professionals who’ve handled a number of RMD penalty waiver requests say a request is most likely to be granted when the mistake was due to an error by a financial institution or the serious illness or mental incapacity of the taxpayer. It also is likely that a penalty will be waived if a third party, such as a court or financial institution, has tied up the IRA. You also might be granted a waiver if your IRA owns hard-to-value assets and you didn’t receive a valuation in time or the valuation later was revised.

In cases for other types of penalties, waivers sometimes are granted when someone for whom the taxpayer was a caretaker had a serious illness. Other than that, we have no guidance. If you believe there’s a reasonable cause, you might as well file a penalty waiver request. The worst that can happen is the IRS denies the waiver and you have to pay the penalty.

To obtain a penalty waiver, you have to take reasonable steps to remedy the mistake. As soon as you are aware an RMD was inadequate, you need to distribute the shortfall. In most cases you simply distribute the amount of the shortfall. In some cases you have to follow a formula in the IRS regulations that requires you to allocate IRA earnings and losses that occurred since the year when the RMD should have been taken. Avoiding that formula is another reason to have the shortfall distributed as soon as you’re aware of it.

It is best to receive the distribution in the form of a check so you can make a copy of the check and submit that with your penalty waiver request. If the distribution is made in another form, be sure to have documentation proving the distribution. Don’t combine this distribution with any other distribution or shortfall. You want to clearly show the IRS the amount was distributed. When the shortfalls were made over more than one year, make separate distributions for each year so that you’ll have clean, clear documentation.

Once distributed, the shortfall is included in your income for the year the distribution actually was made. You don’t try to include in the gross income for the year it was supposed to be taken but wasn’t.

Now, you’re ready to file for the penalty waiver.

You file for the waiver on Form 5329, using Part VIII. If you haven’t already filed your income tax return for the year the mistake was made, you can include Form 5329 as part of your return for that year. Otherwise, you file 5329 by itself. File a separate 5329 for each year there was a mistake.

Enter on line 50 the amount of the RMD that was supposed to be taken. On line 51, enter the RMD actually taken. On line 52, enter zero, not the difference between lines 50 and 51. You enter the zero, because you’re requesting a waiver of the penalty. Also, if you can, write “RC” in the margin next to line 52.

Finally, attach to Form 5329 a statement describing your reasonable cause and proof the shortfall has been distributed.

The IRS will take a few months to respond. You’ll receive either a notice that the return was accepted as filed or a bill for the penalty. If Form 5329 is included with your regular tax return, you won’t receive an acceptance notice. You’ll receive either a bill for the penalty or nothing.

Don’t include a check for the penalty with your return. Old versions of the instructions to Form 5329 say to do that, but recent versions don’t.

Details about the penalty are in IRS Publication 590-B and the instructions to Form 5329. Or you can read the IRS regulations for tax code §4974(d).