Wednesday, August 29, 2012
IRS to Snoop On Your IRA
Let’s talk about IRAs – Individual Retirement Accounts.
Why? By mid-October the IRS is to report to Treasury its plans to increase enforcement of IRA contribution and withdrawal errors. TIGTA projects that there could be between $250 million and $500 million in unreported and uncollected IRA annual penalties. This is low-hanging fruit for a Congress and IRS looking for every last tax dollar.
So what are the tax ropes with IRAs? Let’s talk first about putting money into an IRA.
For 2012 you can put up to $5,000 into an IRA. That amount increases to $6,000 if you are age 50 or over. You can put monies into a regular IRA, a Roth IRA or a combination of the two, but the TOTAL you put in cannot exceed the $5,000/$6,000 limit. That $5,000/$6,000 limit decreases as your income increases IF you are covered by a plan at work. If you have a 401(k)/SIMPLE/SEP/whatever at work, you have to pay attention to the income limitation.
What errors happen with contributions? Let me give you a few examples:
(1) Someone is over the income limit but still funds an IRA.
(2) Someone funds their (say 2011) IRA after April 15 (2012) of the following year. An IRA for a year HAS to be funded by the following April 15th. There is no extension for an IRA contribution, even if the underlying tax return is extended. If you make an IRA contribution on April 20, 2012, that is a 2012 IRA contribution. It is not and cannot be for 2011, because you are beyond the maximum funding period for 2011. Say that you fund your 2012 IRA again by April 1, 2013. Congratulations, you have just overfunded your 2012 IRA. The IRS will soon be looking for you.
(3) You have no earned income but still fund an IRA. What is earned income? An easy definition is income subject to social security. If you have income subject to social security (say a W-2), you may qualify for an IRA. If you don’t, then you do not. If I am looking at a return with a pension, interest, dividends and an IRA deduction, I know that there is a tax problem.
What happens if you over-fund an IRA? Well, there is a penalty. You also have to take the excess funding out of the IRA. The penalty is not bad – it is 6%. This is not too bad if it is just one year, but it can add-up if you go for several years. Say that you have funded $5,000 for seven years, but you actually were unable to make any contribution for any year. What happens?
Let’s take the first year of overfunding and explain the penalty. You overfunded $5,000 in 2005. The first penalty year for 2005 would be 2006. Here is the math:
2005 IRA of $5,000
2006 $5,000 times 6% = $300
2007 $5,000 times 6% = $300
2008 $5,000 times 6% = $300
2009 $5,000 times 6% = $300
2010 $5,000 times 6% = $300
2011 $5,000 times 6% = $300
2012 $5,000 times 6% = $300
So the penalty on your 2005 IRA of $5,000 is $2,100.
Are we done? Of course not. Go through the same exercise for the 2006 contribution. Then the 2007 contribution. And 2008. And so on. Can you see how this can get expensive?
As bad as the penalty may be on excess IRA funding, it is nothing compared to the under-distribution penalty. To better understand the under-distribution penalty, let’s review the rules on taking money out of an IRA.
The first rule is that you have to start taking money out of your IRA by April 1st of the year following the year you turn 70 ½.
From the get-go, this is confusing. What does it mean to turn 70 ½? Let use two examples of a birth month.
Person 1: March 11
Person 2: September 15
We have two people. Each celebrates his/her 70th birthday in 2012. Person 1 turns 70 ½ in 2012 (March 11 plus 6 months equals September 11), so that person must take a minimum IRA withdrawal by April 1, 2013.
Person 2 turns 70 ½ in 2013 (September 15 plus 6 months equals March 15). Person 2 must take a minimum withdrawal by April 1, 2014.
I am not making this up.
Say you are still working at age 70 ½, and the money we are talking about is in a 401(k). Do you have to start minimum distributions? The answer is NO, as long as you do not control more than 5% of the company where you work. What if you roll the 401(k) to an IRA? The answer is now YES, because the exception for working is a 401(k)-related exception, not an IRA-related exception.
Let’s make this more confusing and talk about withdrawals from inherited IRAs. We are now talking about a field littered with bodies. These are some of the most bewildering rules in the tax code.
Inherited does not necessarily mean going to a younger generation. A wife can inherit, as can a parent. The mathematics can change depending on whether you are the first to inherit (i.e., a “designated” beneficiary) or the second (i.e., a “successor” beneficiary).
There are several things to remember about inherited IRAs. First, the surviving spouse has the most options available to any beneficiary. Second, the IRA beneficiary (usually) wants to do something by December 31st of the year following death. Third, a trust can be the beneficiary of an IRA, but the rules get complex. Fourth, your estate is one of your worst options as your IRA beneficiary.
Did you know that you are supposed to retitle an inherited IRA, being careful to include the original owner’s name and indicating that it is inherited, e.g., Anakin Skywalker, deceased, inherited IRA FBO Luke Skywalker? Did you know that a common tax trap is to leave out the “deceased” and “inherited” language? Without those magic words, the IRS does not consider the IRA to be “inherited.” This can result in immediate tax.
Having gone though that literary effort, it seems understandable that you are not to commingle inherited IRAs with your other IRAs. Heck, you may want to keep the statements in a separate room altogether from your regular IRAs, just to be extra safe.
Forget about a 60-day rollover for an inherited IRA. A rollover is OK for your own IRA but not for an inherited IRA. Mind you, you can transfer an inherited IRA from trustee to trustee, but you do not want to receive a check. You do that – even if you pay it back within 60 days - and you have tax.
Let’s say you inherit an IRA from your mom/dad/grandmom/granddad. Payments are reset over your lifetime. You must start distributions the year following death. What if you don’t distribute by December 31st of the following year? The IRS presumes you have made an election to distribute the IRA in full within five years of death. So much for your “stretch” IRA.
One more example. You have IRA monies at Fidelity, Vanguard, T. Rowe Price, Dreyfus and Janus. When you add up all your IRAs to calculate the minimum distribution, you forget to include Dreyfus. What just happened? You have under-distributed.
How bad is the penalty for not taking a minimum distribution, you ask? The penalty is 50% of what you were required to take out but did not. 50 PERCENT!!! It is one of the largest penalties in the tax code.
EXAMPLE: Let’s say that the Dreyfus share of your minimum distribution was $1,650. Your penalty for inadvertently leaving Dreyfus out of the calculation is $825 ($1,650 times 50%).
The IRS has traditionally been lenient with the under-distribution penalty. Perhaps that is because the intent is to save for retirement, and this penalty does not foster that goal. Perhaps it is because a 50% penalty seems outrageous, even to the IRS. However, will a Congress desperate for money see low-hanging fruit when looking at IRAs?
If you are walking into an IRA situation, consider this one of those times in life when you simply have to get professional advice. The rules in this area can bend even a tax pro into knots. I am not talking about necessarily using a tax pro for the rest of your life. I am talking about seeing a pro when you inherit that IRA, or when you close in on age 70 ½. Be sure you are handling this correctly.