New Rules Imposed By IRS Make Transactions More Precarious

Published on July 25, 2012

The Wall Street Journal recently released an article warning investors to be more meticulous when it comes to avoiding account mistakes.

The article, “IRA Rules Get Trickier,” alerts IRA investors to the stricter policies the IRS will be enforcing in the coming months regarding IRA blunders. According to WSJ,

“The government lets millions of dollars in tax penalties on IRAs go uncollected each year—$286 million in 2006 and 2007 alone for missed withdrawals and contributions that break the rules. The reasons range from bureaucratic hurdles to tax forms that don’t provide enough information, according to a report by the Treasury Inspector General for Tax Administration, the federal tax watchdog.”

It was also reported that “The agency will report to the Treasury Department by Oct. 15 on how to go after taxpayers who make contribution or withdrawal errors, according to spokesman Eric Smith, who declined to provide details. The possibilities include additional paperwork that IRA owners would have to file with their tax returns and stepped-up audits, mainly matching up distribution reports from IRA custodians to individuals’ tax returns.”

A common penalty taxpayers are facing occurs when they fail to take Required Minimum Distributions (RMDs) after reaching age 70 ½. Failing to take an RMD means they can face a penalty of 50% of the amount they should have withdrawn. “Accountants and lawyers have to be aware of the potential liability, because there’s no statute of limitations on those 50% penalties,” says Seymour Goldberg, a lawyer and CPA in Woodbury, N.Y.

In addition to failing to take RMDs, taxpayers are also finding themselves in another predicament; they are making excess contributions to their IRAs. “Making an ‘excess contribution’—meaning you contributed more than the annual limit to a traditional IRA or made a Roth contribution when your income was too high—can cost you 6% of the amount that wasn’t allowed in the account,” stated the WSJ article.

The penalty fees associated with doing this can add up quickly if the mistake goes undetected for several years. Keep in mind that there is no statute of limitations in cases where the offender doesn’t file a specific form, 5329, to report the problem, according to a 2011 Tax Court ruling.

Another potential snag, as reported by WSJ: If your money is in a 401(k), and you still are working for the employer that sponsors that account when you turn 70½ and you don’t own more than 5% of the company, you don’t have to make withdrawals from that account. But if you roll over your 401(k) to an IRA, you do.

The final common penalty taxpayers are facing occurs when they inherit an IRA. “When you inherit an IRA, the rules for making withdrawals are different from those governing regular IRAs, and even some financial professionals don’t know them.” Custodians of these accounts are also not required to alert people who inherit IRAs that they are required to take distributions, thus making it imperative that financial advisors are aware of these rules.

• If IRA owners are older than 70½ when they die, and they hadn’t taken their required withdrawal for that year yet, the person inheriting the account has to do so for that year and report it as ordinary income on his or her own tax return.
• If you inherit an IRA from anyone other than your spouse and you are a designated beneficiary, you have to, at the very least, take withdrawals across your own life expectancy starting the year after the death. (Again, you would use the life-expectancy tables in Publication 590.)
• If you inherit an IRA from your spouse, you can either roll the account into your own IRA or set up an inherited IRA and postpone taking required distributions until the deceased spouse would have turned 70½.

In the end, it is important for both taxpayers and financial advisors to be doing their due diligence when it comes to keeping up to date on IRS tax code, rules, and regulations.

To read the Wall Street Journal article, “IRA Rules Get Trickier,” in its entirety, click here.