IRS Beginning to Get Serious About IRA Violations
After years of what at best was haphazard enforcement, the IRS is starting to more systematically look for violations of the rules governing individual retirement accounts (IRAs). And with good reason; there's a lot at stake. Americans hold more than $4 trillion in IRAs.
The IRS was more or less forced into action by a Treasury Inspector General for Tax Administration report a couple of years back that concluded IRA violations have been growing, and further estimated that more than half a million taxpayers either missed their "required minimum distribution" (RMD) or conversely contributed more to IRAs than was allowed during the years they studied.
As you will see, the cost of even innocent mistakes can be quite steep. Let's look at some common problems the IRS is looking for:
Failure To Take RMDs The law requires IRA owners to begin taking RMDs from traditional IRAs after they turn age 701/2. After all, the government eventually wants its revenue back (and then some) from the tax deductions you took earlier.
To find possible violations of the RMD requirement, the IRS is programming its document-matching system to use the forms IRA custodians send out to help find RMD violations.
IRA custodians generally are required to send out a letter early each year calculating your RMD and reminding you to take distributions (this doesn't apply for inherited IRAs although some do it anyway). A failure to fully take the RMD results in a penalty of 50% of the required amount.
What should you do if you are late? You will need to file a Form 5329 to calculate the penalty. If you have an acceptable excuse (e.g., an illness, family crisis or maybe even confusion about your first RMD), you can attach a letter and ask that the penalty be waived. It never hurts to ask!
It is not necessary that the RMD be taken out of each account, but only that the total RMD of all your accounts collectively is taken. So, it is entirely acceptable to take the total RMD from even just one account, if that's what you want to do. Some find that confusing, however, and prefer to have each account distribute its respective share.
Additionally, if you like you can take the RMD in periodic withdrawals throughout the year instead of as a lump sum. Just be sure by the end of the year you have taken the entire amount.
By the way, Roth IRAs don't have RMD requirements, so if that is all you have, no worries.
Early Withdrawals Normally, you cannot take a distribution from an IRA before age 591/2 without paying a 10% early withdrawal penalty in addition to the regular income tax on the money. There are some exceptions, albeit confusing ones. For instance, you can take money from an IRA to pay college bills.
When an early distribution is taken, you will receive (and so will the IRS) Form 1099-R showing the amount taken. You will have to pay the 10% with your return or, if you believe you don't owe it, file Form 5329 and indicate why you're exempt.
I suggest you read both IRS Publication 590 and the instructions for Form 5329 before you take a distribution to see if your situation fits into a specific exception. If not, either don't do it or consider taking "substantially equal periodic payments". It's probably a good idea to get some help if you decide to take that route.
Rollover Issues When you take money out of an IRA, you have 60 days to roll it into another IRA without it being considered a taxable withdrawal. The IRS can waive the 60-day limit for cause, but their often reticent to do so.
The best roll over approach is what is known as a trustee-to-trustee transfer where the money moves directly from one custodian to another, thus avoiding the issue altogether.
Excess Contributions The amount that can be contributed to an IRA is limited and can be different depending on your age, amount of earned income and the tax year involved.
If you contribute too much, you could be subject a 6% "excise tax" on the excess contribution, and this penalty is imposed for every year the excess money continues to sit in the IRA.
Fortunately, you can fix an excess contribution up until six months after the April 15 tax return due date by withdrawing the excess plus any earnings on the excess amount (those earnings will be taxable).
Using an IRA to Start a Business Generally you are prevented from investing your IRA money in your own business. But some advisors have pushed a maneuver where you roll IRA money into the pension plan of a new business and then use that plan to fund the startup.
The IRS calls these ROBS, for "rollover as business startups", and while it hasn't explicitly barred the technique, IRS officials warn that when they examine ROBS they tend to find "technical violations."
Such violations could lead the new pension plan to be disqualified, thus making all funds in it subject to immediate tax, plus that 10% penalty for those under 591/2. Not worth the risk in my opinion.
