As the so-called "fiscal cliff" looms, and the debate continues about whether to solve the country's fiscal woes with tax increases and/or spending cuts, a third option to help the situation is also emerging: do a better job collecting the taxes already due under the laws as they're written now. In the latest such shift, the word is out that the IRS is becoming less and less lenient regarding IRA mistakes, given the significant potential penalties involved - for instance, failing to take a required minimum distribution results in a penalty that is a whopping 50% of the RMD itself, and the penalty for an improper IRA contribution is 6%, per year, potentially accumulating for years on end. And there is potential that the IRS' efforts could extend further, leading to a crackdown on perceived abusive IRA strategies. As a result, clients should be more cautious than ever to comply properly with all IRA rules, including the timely distribution of RMDs, and proper compliance with all IRA contribution and rollover limits, and be wary of aggressive IRA strategies. From the planner's perspective, it's more important than ever to not only help clients comply properly with the rules, but to be cautious about giving accurate IRA advice, or run the risk that if the client ends out with IRS penalties, that the advisor - or his/her E&O insurance - may end out sharing in the high penalty cost to fix the mistake.

The inspiration for today's blog post was a recent article in the Wall Street Journal about 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' position isn't entirely surprised; in an environment where we face significant Federal budget deficits, it's far more easier politically to raise revenue by simply "better enforcing" the existing rules on the book, than it is to either cut spending or pass new tax law increases. And 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 alone.

IRS Penalties On The Table

In practice, there are two primary IRA penalties on the table for the IRS to go after.

The first penalty is for failing to take a required minimum distribution (RMD), and the penalty is a whopping 50% of the amount of the RMD that wasn't taken. Thus, for example, if the IRA was $1,000,000 and the client didn't realize it was time to take an RMD having reached age 70 1/2, with a life expectancy of 27.4 years according to the Uniform Distribution Table, the first RMD should have been $36,496, which means the penalty is a whopping $18,248 - in addition to the fact that the individual still needs to take the RMD of $36,496 itself, which is also taxable income subject to state and Federal taxation! In the past, taxpayers could request a waiver of the IRA RMD penalty by correcting the "error" immediately, and filing Form 5329, and the waiver was commonly granted; now, however, it's unclear whether the IRS is still as likely to acquiesce.

The second IRA penalty that the IRS can pursue is the 6% excess contribution penalty tax. Although the penalty amount is far smaller than the somewhat draconian 50% penalty for failing to take an RMD, it is arguably the more common penalty, due to the fact that it can apply in so many different circumstances. For instance, an individual who contributed to a Roth IRA but was over the income limit would be subject to the excess contributions penalty. But so would an individual who improperly completed an IRA rollover; for instance, if the rollover occurred after the 60 day time window, but the money was put into the IRA anyway, it is technically an excess contribution, and the entire rollover may be subject to the penalty. And notably, every year that an excess contribution remains in an account, it is subject to a new year's excess contribution penalty; consequently, an improper contribution remains at risk even years later, and can't simply slip past the statute of limitations (although it would be too late to merely unwind the contribution or recharacterize it to avoid penalties), and in fact can incur significant penalties from the cumulative result of several years' worth of improper contributions.

How Can The IRS Catch Wrongdoers?

In the more distant past, it was relatively difficult for the IRS to catch wrongdoers, even if IRA mistakes were made. However, since 2004, IRA custodians have been required to not only provide a calculation of RMDs to IRA owners, but also to the IRS on Form 5498. Consequently, in reality it's actually quite easy for the IRS to determine whether RMDs have been taken properly: since the IRA custodian will issue a Form 5498 to the IRS to report the RMD that was required, the IRS simply needs to wait and see if there is also a Form 1099-R issue for the taxpayer to report an IRA distribution for that same individual. If the total of the 1099-Rs don't at least add up to the RMD from Form 5498, and/or are not reported as income on the individual's own tax return, clearly an RMD was missed, and the penalty should apply.

In the case of the excess contributions penalty, it's somewhat harder for the IRS to catch mistakes. While 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), 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 would have to audit further to determine whether they were done in a timely manner and/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 towards collecting various IRA penalties also raises the risks of various Roth conversion strategies that have become increasingly popular in recent years, 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. As I've written in the past, these strategies are controversial at best - after all, it's hard to argue that contributing to a non-deductible traditional IRA and immediately converting it isn't an abuse of the tax law, given that the strategy is even called a backdoor Roth contribution! And in an environment where the IRS is trying to raise tax revenue by "better enforcing" existing laws, there's an added risk that the IRS will pursue the matter, especially since winning one court battle on the issue could open the door for the IRS to enforce the matter against everyone who has been using the strategies.

Implications For Financial Planners

The looming crackdown on IRAs has several important implications for financial planners.

The first is simply that it's more important than ever to help clients follow the basic IRA rules, including only making contributions that are permissible based on income, and completing required minimum distributions - including RMDs from inherited IRAs - in a timely manner.

The second is that there's now an increased risk that mistaken advice by a financial planner could turn into real trouble down the road. For instance, incorrect guidance about how to calculate or complete an RMD, IRA rollover, inherited IRA transfer, or other strategy, is more likely than ever to result in some real penalties for clients - penalties that clients may try to recover from their advisor (or their advisor's E&O policy!) if necessary. So make sure you really know your IRA rules going forward.

The third implication is that now may not be the best time to be aggressive in various IRA strategies, such as the numerous Roth conversion strategies that have become popular lately. The more pressure there is on the IRS to raise additional revenue with better enforcement, and the more people there are engaging in strategies that are perceived as abusive by the IRS, the greater the likelihood that the IRS will try to crack down on the strategies and pursue "wrongdoers" - and notably, if the IRS' view is that the strategy was abusive all along, then not only may the rules be changed to make it clear the strategy is not allowable, but those who have already done the "improper" strategy might not be grandfathered under any updated rules. Be cautious that aggressive IRA strategies and advice don't come back to bite both the client and the planner.

But overall, the bottom line is simply this: the IRS is stepping up enforcement and going after individuals who make IRA mistakes, so be certain you don't get caught up in the crossfire.

So what do you think? Would a looming IRS crackdown on IRAs make you do anything different in your practice? Would you change your views on recommending certain strategies? Do you think it's a good thing that the IRS is stepping up enforcement on the rules as written, or is this a negative sign of things to come?

  • dorothy strackbein

    Great IRS info

  • Barb White

    I recently had to teach Wm. Penn insurance company that if the decedent hadn’t taken the RMD for the year, that the bene’s needed to (under their SS #’s). A mess was in the works, but averted. They’re just pushing product – and gathering commissions.

  • Dean

    Heads up guys, the IRS is early on in an all out war to take money from investment accounts. That is where the money is. They do not even look at low income families who commit massive tax fraud through EITC, they go after the tax preparers.
    Now, they see a pot of gold in your clients IRA accounts, and they want a BIG cut.
    My advice, get licensed as a tax professional and learn how to stay up on top of both worlds. With the never ending starvation of government for more money, and our clients being the ones with money, it is the only way you will be able to protect yourself and your clients.

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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