The Wall Street Journal article IRA Rules Get Trickier certainly caught my attention. Were the already too-convoluted rules getting even trickier? Not really, as the title of this article confirms, the rules haven’t changed, but the IRS has announced its intention to get tough on enforcement. Note, this article’s title was exactly how fellow Usenet poster Alan referred to the WSJ article, since I couldn’t improve on perfection, it’s what I am using today.
There’s $4.9 trillion dollars in IRA accounts, and those who don’t follow the rules are supposed to pay a penalty. The Treasury Inspector General for Tax Administration estimates over a quarter billion dollars in penalties went uncollected in just 2006 and 2007. Compared to the deficit, this may be peanuts, but it all adds up.
There are two situations which are common penalty items and easy to fall prey to.
There are income limits, above which, you are not not permitted to contribute to a Roth IRA. In 2012 it’s a modified adjusted gross income (MAGI) of $125K or over if single, $183K or over if married filing joint. If you make a deposit that is not allowed, there is a 6% penalty until it’s withdrawn. 6% each year until you correct this error. No statute of limitations. An excess deposit to a traditional IRA will incur the same penalty. This type of error is far tougher to make if you are using tax software, the attempt to make a disallowed deposit will raise a large error flag. Sorry to the “do it by hand tax pros,” this is one of your common avoidable mistakes.
The other error is to miss your required minimum distribution (RMD) of either a traditional or Roth IRA. Roth IRA?? Yes. If the Roth IRA is inherited, the non-spouse beneficiary must start to take RMDs by the end of the year following the death of the Roth IRA owner, same rules as for Traditional IRAs that are inherited by a non-spouse. The Roth owner had no RMD, but the traditional IRA owner must start taking withdrawals after reaching age 70-1/2. The penalty for not taking the proper amount of one’s RMD is 50% of the shortfall. Now, that’s a penalty! The IRS has been lenient on this 50% penalty, waiving it for a decent excuse, but I suspect they’ll soon be less kind. That IRS has a form for everything, and the form to pay your penalty is Form 5329 “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” Curious, that in the instructions for this form is the statement “If the trustee, custodian, or issuer of your IRA informs you of the minimum required distribution, you can use that amount.”
Why curious? Because many people go to pros and the pros are making mistakes. I help an 80 year old with her IRA, each year converting just enough from the tradition IRA to Roth so her taxable income is at the top of the 15% bracket. Tough to do this to the penny, with the mutual fund distributions coming so late in the year. So at tax time we recharacterize any excess over the 15% bracket, money that would otherwise get taxed at 25%. Now, the one gotcha here is that the amount recharacterized must be included in the RMD calculations, as if it were in the account on December 31 of the prior year. Since most brokers will calculate your RMD soon after year end, if you have a recharacterization, you must request they redo the math for you. So, I made the request, and received a response,”The RMD amount for a given tax year is based off the balance of the account at the close of business on December 31 of the prior year along with a life-expectancy factor determined by the IRS. An RMD amount is not altered by activity within the account over the course of the year.” Needless to say, I was mortified. This response came in an email and I called the broker’s retirement department where the rep who answered was also mortified. She thanked me for my kindness, told me of course I was right to request a new RMD figure and she’d talk to the team who responds to question via email to bring them up to speed. The RMD number was fixed both on the account web site and was mailed to the woman I assist.
A tough lesson today. I think it’s fair to say that our tax code has become so convoluted that even the pros are making mistakes. Mistakes that can cost you money.