IRA Rules Get Trickier

by Kelly Greene

Uncle Sam is about to get a lot tougher on individual retirement account mistakes—and that could trip up investors who aren't careful.

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.

Now the Internal Revenue Service, which has been cracking down on secret foreign accounts and beefing up audits of high earners in recent years, is turning its attention to IRA snafus.

Some 46 million U.S. households, or two out of five, hold a combined $4.9 trillion in IRA assets, according to the Investment Company Institute. The more-aggressive enforcement means those investors need to make sure their accounts are in order—quickly.

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.

"It's a wake-up call for anyone who has an IRA," says Martin Censor, a manager at the American Institute of Certified Public Accountants. "The government needs money.…This is low-hanging fruit."

The tax penalties for running afoul of IRA rules are tough. People who fail to take a "required minimum distribution," usually starting at age 70½, can be hit with a penalty of 50% of the amount they should have withdrawn. The same levy applies to required withdrawals from an inherited IRA, including inherited Roth accounts. (Contributions to Roth IRAs aren't deductible, but withdrawals are tax-free after holding requirements are met.)

The IRS also is keeping a close eye on contributions to make sure taxpayers aren't secretly socking away extra money in an attempt to rack up tax-free earnings. The 2012 contribution limits for traditional and Roth IRAs are $5,000 per person, or $6,000 for people 50 or older. There are income limits for qualifying to make Roth contributions as well.

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. This can add up fast in cases where an excess contribution went undetected for many years. Sometimes, excess contributions also result when a transfer of assets from one IRA to another doesn't get done in the time allowed.

Arthur Elkin, a 60-year-old retired federal-government worker in Delaware, didn't realize he and his wife had made excess contributions to their Roth IRAs for seven years until he started working with a new accountant. Their income had topped the $150,000 maximum then allowed for making contributions, but their previous accountant hadn't caught the problem.

The couple had to file seven years of amended returns, withdraw the contributions and pay thousands of dollars in penalties and interest. The worst part, Mr. Elkin says: realizing that, had he kept preparing his own tax returns, as he had in the past, the software probably would have caught the error.

Although the IRS hasn't tipped its hand about its looming enforcement effort, IRA experts are urging accountants, financial planners and lawyers to brush up on the rules and help their clients clean up their IRAs before the IRS forces them to do so later this year or next.

"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.

The federal government has already begun questioning some taxpayers about their IRA activity.

In Austin, Texas, CPA Janet Hagy has had clients get "odd" IRA notices in the past few years, after they withdrew money from one IRA and deposited it in another account within the required 60 days. "They still get an IRS notice making them prove they rolled it over" and didn't simply withdraw the money without paying tax on it, she says.

And in Mooresville, Ind., CPA Martin James had to prove that a couple spreading the income they created in 2010 when they converted a traditional IRA to a Roth across their 2011 and 2012 tax returns, a one-time deal for conversions done that year, didn't owe $25,000 in taxes. He also had to show that another couple, who rolled money from an IRA into a health savings account, which is allowed one time, did it correctly.

Mr. James says he is baffled by the inconsistencies in who gets IRA notices, since a number of his clients did 2010 Roth conversions and moved assets from IRAs to HSAs. He chalks it up to computers not being able to match up the forms involved.

Worried that the IRS might look askance at something you have, or haven't, done with your IRA? Here are some of the most common mistakes, and how you can right them before the government detects your wrongs.

Failing to Withdraw

People in their 70s have to start taking money out of IRAs and pay the federal government its due. But the rules get complicated quickly.

IRA owners must start taking their required withdrawals from traditional IRAs by April 1 of the year after they turn 70½. Those withdrawals are calculated by dividing the total IRA balance as of Dec. 31 of the year before the owner turns 70½ by life expectancy, found in a table in IRS Publication 590. You use a separate life-expectancy table in the same publication if your spouse is more than a decade younger than yourself and your sole heir.

The IRS considers all of your IRAs to be a single account, so it is best to streamline where you can. If you take the entire withdrawal from one account and none from another, the other account's custodian still will report that you are subject to a required withdrawal.

For people with smaller IRAs, there may be some relief. A congressional bill introduced earlier this year would exempt IRAs worth less than $100,000 from withdrawal requirements.

There is big money at stake: For 2006 and 2007, the Treasury Inspector General for Tax Administration estimated that 255,498 people failed to comply with the withdrawal requirements, leaving more than $348 million in accounts that should have been subject to income tax.

According to the inspector general's 2010 report on IRA compliance, the IRS conducted a project to pinpoint people with account balances of at least $1 million who didn't appear to take required minimum distributions. The 111 IRA holders were sent compliance letters, and 88 withdrew a total of $6.1 million from their accounts. As of 2010, an IRS compliance unit was working with the remaining 23 to ensure they took their withdrawals.

Another potential snag: 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.

Jean Hockenbrocht, a 76-year-old chocolate-factory worker in Lititz, Pa., says she missed four years of IRA withdrawals because her investment adviser confused those two rules. He had rolled her 401(k) to an IRA and mistakenly told her she could skip the distributions because she was still working.

When she started working with a new adviser, Joe Wirbick, in January, he realized the error, withdrew some $5,000 in missed distributions and helped her write a letter to the IRS. The key, Mr. Wirbick says, "was to let the IRS know that the minute she was made aware of the mistake, she corrected it by making all the previous distributions at once and will continue with future withdrawals." So far, she has received no response from the IRS.

Contributing Too Much

Generally, an excess contribution to a traditional IRA is any amount more than $5,000 a year, or $6,000 if you are 50 or older. But you can't contribute more than your "earned income," which trips up some people who manage their own property and investments, accountants say.

For IRA purposes, earned income includes wages, commissions and alimony, but not rental-property income, a pension or deferred compensation. (The complete list is in IRS Publication 590.)

If you realize you have made an excess contribution before Oct. 15 of the following year, you can correct it by withdrawing that amount, plus any interest. But many people aren't catching the mistakes, according to the IRS's 2010 review, which found that 295,141 people made excess contributions in 2006 and 2007 totaling nearly $1.6 billion.

Keep in mind that there is no statute of limitations in cases where the offender doesn't file a specific form, 5329, reporting the problem, according to a 2011 Tax Court ruling.

Inheriting an Account

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.

Here are the basics: 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 either can 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.

The trouble is that IRA custodians generally don't send annual notices to people who inherit IRAs making them aware of the distribution requirements, because it isn't required under the IRS rules, Mr. Goldberg says.

Even getting the money into an inherited account can be fraught.

Anne Baumann, a 58-year-old social-services caseworker in Rockland County, N.Y., was told by her father's financial adviser after his death that she had inherited an IRA worth about $30,000, and she had a choice between a lump-sum payout or five years of installments. She signed the paperwork to take it all at once.

When she relayed the news the next day to her own adviser, Beth Blecker, chief executive of Eastern Planning in Pearl River, N.Y., Ms. Blecker made several calls to the firm, and finally to its legal department, to get the check stopped.

Instead, she got the IRA transferred to another custodian and retitled as an inherited account. That way, Ms. Baumann will get payments across her life expectancy, and any earnings in the account are tax-deferred.

"I specifically asked the guy if I could roll it over, and he said, 'That's not one of the choices. You have to take it,'" Ms. Baumann recalls. "Now, I get a distribution every year."

Some cases don't end as well. Ed Slott, an IRA consultant in Rockville Centre, N.Y., recently came across the case of a 31-year-old woman who inherited an IRA at age 17 when her father died. Her family's adviser made a mistake, putting the $170,000 into her own IRA rather than retitling the father's account as an
inherited IRA.

Now, the entire account balance is going to pay penalties since the IRA was really a taxable distribution 14 years ago, Mr. Slott says.

For that problem, "there was no solution, and it's not right," he says. "She was innocent. All that had to happen was an adviser put the money in an inherited IRA for her from day one."

READ MORE