How Do Your Avoid IRS Penalties on Your IRA?

Wendy Shick | September 21st, 2012

With our government requiring more cash each year, there is growing sentiment is the financial community that the IRS is becoming more vigilant in obtaining all revenue available related to Individual Retirement Accounts (IRAs). According to a recent article, the Treasury Inspector General for Tax Administration estimates that the IRS failed to collect as much as $286 million of revenue in 2006 and 2007 alone. From a political aspect, it is easier to raise revenue by simply enforcing the existing rules, than it is to cut spending or pass a new tax increase.

Since 2004, the IRA custodians have been required to file Form 5498 to the IRS. Starting in 2009, the form increased the amount of information provided to the IRS. This form provides the IRS with the balance of an IRA, contributions, rollovers and details of the required minimum distribution (RMD) calculation. The IRS computer system is becoming more adept at recognizing when the rules are not being followed. In the past year, IRS has been issuing more notices relative to distributions, IRA rollovers and Roth conversions. The IRS is requesting documentation to confirm that these types of transactions were reported correctly on the tax return and followed the applicable rules.

Below are three areas of concern to the IRS.

  1. Required Minimum Distributions (RMD) – IRA owners must start taking their required withdrawals from traditional IRAs by April 1 of the year after they turn 70 ½. The IRS provides two tables to determine the amount of the RMD. Usually the IRA custodian will also provide a calculation. If the RMD is not taken, the penalty is 50% of the RMD. However, if the error is corrected quickly by withdrawing the funds late, Form 5329 can be completed to request a penalty waiver. In the past, this method has been very successful and hopefully that will continue in the future.
  2. Contributing Too Much – There are a variety of limitations on the amount allowed to be contributed to a traditional IRA and Roth IRA. If those limitations are exceeded, there is a 6% penalty on the amount of excess contribution for each year that the contribution remains in the IRA. If your tax preparer realizes an excess contribution exists, it can be withdrawn up to October 15 of the following year to avoid penalties. If not withdrawn timely, the penalty accumulates. In 2010 an IRS review found that 295,141 people made excess contribution in 2006 and 2007 totaling nearly $1.6 billion.
  3. Inheriting an IRA – The rules for an inherited IRA are different and more complicated for RMDs and rollovers. Contributions are not allowed to be made to inherited IRAs. The best advice is to consult with both the IRA custodian and tax advisor before withdrawing or rolling over these funds. Make sure you receive accurate advice before proceeding. An incorrect move can produce an unwelcome 100% taxable transaction instead of continued tax deferral. The IRS has very few remedies for innocent mistakes relating to inherited IRA rollovers.

Contact Rea’s Personal Finance Team

With the IRS cracking down on IRA distributions, contributions and rollovers, many people who thought they were following the laws might find themselves the targets of enforcement.  Not sure if you’re in compliance with all the regulations?  Worried that you could find yourself the victim of stepped up enforcement efforts?  Contact Rea & Associates.  Rea’s Ohio tax services team will review your IRA to make sure that you’re in compliance, preventing future unpleasant surprises from the IRS.

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