IRA Changes For 2020

 The issue came up last week with a retired client, so let’s talk about it.

What is going on in 2020 with your IRAs?

There are several things here, so let’s go step-by-step:

(1)  Do you have to take a minimum required distribution (MRD) if you turned 70 1/2 in 2020?

ANSWER: No. The new age requirement is age 72.

(2)  What if I turned 70 ½ in 2019 and delayed my initial MRD until 2020?

ANSWER: Thanks to the CARES Act, that initial MRD is delayed one more year – until 2021.

(3)   I am well over 70 ½.  Do I have a MRD for 2020?

ANSWER: No. You can take money out, but you are not required to.

(4)  What if I already took out my MRD?

ANSWER: There are two answers, depending on when you took the MRD.

(a) If you took the MRD in January 2020, there is nothing you can do at this point.

(b)  If you took the MRD after January 31, 2020, you have until July 15, 2020 to return the money.

BTW there is a possible tax trap here. You are allowed only one non-trustee-to-trustee rollover (meaning you received and cashed the check with the intent of paying it back within 60 days) within a rolling 12-month period. If you did this in 2019, you need to check whether you are caught within this 12-month dragnet.

(5)  I have an inherited IRA account. Is there any change for me?

ANSWER: If the decedent passed away before 2020, you do not have an MRD for 2020.

There is a technical point in here if one was waiting five years before emptying the inherited IRS account: 2020 will not be counted as a year. In effect, you now have six years to empty the account rather than five.

(6)  I am having cash-flow issues as a consequence of the virus-related lockdown. I am thinking about tapping my IRA in order to get through. Is there something for me?

ANSWER: There are several changes.

(1) The 10% penalty for pre-age-59 ½ payouts for COVID-related reasons is waived on distributions up to $100,000.

(2) The income tax on the distribution still applies, but the tax can be paid over three years.

(3) And you also have 3 years to put the money back in the IRA. If you do, the money restored will be treated like a qualified rollover.

a.    Remember, this is taking place over 3 years. It is possible that you will have paid income tax on some or all of the money you restore in your IRA. If so, you can file an amended return and get your income tax back.

(7)  I am taking “substantially equal periodic payments” from my IRA. I am under age 59 ½ and needed the money. Is there a break for me?

ANSWER: A SEPP program allows one to avoid the penalty for early withdrawals, but it comes at a price: on has to take withdrawals over a given period of time.

A SEPP is not the same as a MRD, so the new rules do not apply to you.

(8)  Is it too late to fund my IRA for 2019?

ANSWER: Normally, you have until April 15 of the following year to fund an IRA. For 2019, that deadline has been extended to July 15, 2020.

Being Unemployed, Depressed And Owing The IRS

The case is 55 pages long.

Even a tax guy gets tired of marathon reading.

The story got me fired up, however, so let’s talk about it.

A frequent area of taxpayer request for IRS relief from penalties is rollovers of retirement monies, especially IRAs. Used to be that one filed for a Private Letter Ruling to obtain official absolution. Those bad boys are not cheap, as you will pay a tax CPA or attorney to draft the PLR, as well as pay the IRS filing fee. The filing fee alone can run you $10,000.

In 2016 the IRS published Revenue Procedure 2016-47 allowing for alternate means of absolution without requesting a PLR. Even the IRS got tired of taking your money.

Mr Trimmer was a retired cop with the New York Police Department. He was moving on after 20 years with the NPD, taking a security job with the New York Stock Exchange. He needed the job to supplement his pension, as he had two sons going through college. The new job however fell through. He was hosed, as the NYPD does not rehire.

And Trimmer went major depressive. He was antisocial, rarely left the house, neglected his hygiene and grooming – all the classic symptoms.

Somewhere in there he received two retirement checks: one for $99,990 and a second for $710. They lay on his dresser for weeks until he finally got around to depositing them into … his checking account.

COMMENT: If you were thinking a rollover, he flubbed because the roll did not go into an IRA account.

Months later Trimmer and his wife met with their accountant for their taxes. The accountant advised that he transfer the monies to an IRA immediately.

COMMENT: Trimmer was well outside the 60-day window at that point.

The IRS sent him a notice asserting that he failed to report over $100,000 of income and demanded taxes, penalties, interest, a Weimaraner puppy and a month’s pass to Planet Fitness.

It added up close to $40.000.

Yipes!

Trimmer wrote back to the IRS: 

    Dear Sirs:

I am contesting the amount of money said to be owed. Please allow me to explain the situation. In April 2011 I retired from my job and took a pension loan. After my retirement I went through a period of depression and was not managing my affairs. I received my check for the loan and deposited it into Santander bank on July 5, 2011. The money remained in this account until April of 2012 when it was switched to an I.R.A. in the same bank where it remains to this day.

A few points

- There was no deception or spending, investing of the money at all. I received the check and deposited it into the bank.

- My wife and I have been paying taxes for a combined 60 years and NEVER had the least bit a problem.

- There was no harm done to anyone with the money staying in the bank except me (I was receiving 0.25% interest.)

- I switched the money to an I.R.A. before I was notified by the I.R.S.

I am now employed again and am driving a school bus and have a son in college and another a year away. To pay $40,000 in taxes for money that is in an I.R.A. would absolutely cripple my family as it would be 3 years of my salary. Sir no harm was done to anyone. I went through a rough time upon separation from my job, causing me emotional hard times that caused this situation. Penalizing me and my family would not benefit anybody, only cause extreme duress and punish my children who played no part in this situation. I ask you to consider these facts and please come to a fair decision. Please contact me if you need at [phone number redacted].

Thank You,

John Trimmer

I feel sorry for the guy.

Here is the IRS reply:

“The law requires you to roll over your distribution within 60 days of the distribution date. If the roll over exceeds the time frame it becomes fully taxable.”

Nice folk over there.

Here is the tax issue: The IRS can issue waivers for this penalty, but they did not mention such fact to Mr Trimmer or how to apply for a waiver. Heck, they did not even reference Trimmer’s unfortunate circumstances. A reasonable person could question whether anyone even read his letter.

The IRS sent a Statutory Notice of Deficiency, also known as a 90-day letter.

Trimmer filed with the Tax Court.

The IRS went right for the throat:

•  Trimmer did not follow procedures (Rev Proc 2013-16 for the nerds).
• This made the hardship waiver provision “inapplicable.”
•  Since Trimmer had not pressed the point, there technically had been no “final administrative determination.”
• Without that “final,” the Tax Court had no authority over the case.
• In any event, Trimmer had never explained why he was unable to accomplish the two rollovers within 60 days.
• And where is that puppy?

Well, thank you Darth.

The Tax Court seemed to like Trimmer:

(1) OK, so he did not follow procedures.

(2) Not so quick, Sith Lord. How does the IRS reconcile 2003-16 with the following from the Internal Revenue Manual:

Examiners are given the authority to recommend the proper disposition of all identified issues, as well as any issued raised by the taxpayer.”

(3) The examiner’s authority to consider a hardship waiver “strongly implies” that the taxpayer may request the waiver.

COMMENT: 

(4) From the Court:

As might be expected from a self-represented taxpayer unversed in the technicalities of the tax law, he did not expressly cite section 402(c)(3)(B). But his letter leaves little doubt that he was seeking a hardship waiver of the 60-day rollover requirement….”

(5) The Court points out that the examiner 

… did not decline to consider Mr. Trimmer’ request, did not request that petitioners provide any additional information, and did not advise them that they were required to submit a private letter request or do anything else in particular to have their request considered.”

(6) If anything, the examiner wrote Mr. Trimmer that

… you do not need to do anything else for now. We will contact you within 60 days to let you know what action we are taking.”

(7) And 3 days later the examiner

… wrote petitioners again, denying requested relief, not on the basis that petitioners had requested it in the wrong manner or had provided insufficient information, but on the basis of cursory and incomplete legal analysis that failed to take into account the provision for hardship waivers under section 402(c)(3)(B).”

The Tax Court found in favor of Trimmer. He could do a late rollover. He was not subject to tax or penalty and could keep his Weimaraner puppy.

Good.

But it should not have gone this far. We are not in unexplored tax country here.

One could argue that our tax system is near-to breaking when you have to hire a professional to resolve near-routine tax problems. This man did not roll-over his money within 60 days. He was clinically depressed for a while. I can see requesting a doctor’s letter attesting to the taxpayer’s condition, but this is not cutting-edge tax practice.  

So why the HBO-level drama?

Here is one commentator’s remark:

We have a lazy revenue agent who probably just glances over the response. Is it the revenue agent’s fault? No, I don’t blame the revenue agent. With budget cuts, the caseloads of revenue agents are insane.”

I was listening until the “overworked” card. Seriously? I recommend this revenue agent not consider a career as a tax CPA, although – as a positive – it would probably be a short one.  

I do think our case highlights a disturbingly under-skilled IRS employee.

I also think it shows a trigger-happy IRS assessing penalties on anyone for anything. That examiners are throwing them around like sugar packets from a McDonalds drive-through indicates that they are under pressure to sweeten the take, irrespective of whether penalties are appropriate. Those penalties are under-the-table income to an IRS already facing a tight budget.

We have spoken before of a goose-and-gander bill, requiring the IRS to pay a taxpayer when the agency acts recklessly. The IRS already has people on payroll to pin your ears back, whereas you have to hire someone like me to fend them off. Their incremental cost to chase you is minimal, but your incremental cost to defend yourself can be significant if not ruinous.

Our goose-and-gander bill might or might not have protected Trimmer specifically, but eventually the IRS would lose enough cases to reconsider the automatic-tax-and-penalty-no-reasonable-cause-raised-middle-finger policy it has adopted. Cutting a check really focuses one’s attention.

When Hardship Is Not Enough

Let’s talk a bit about hardship distributions from your retirement plan – perhaps your 401(k).

You may know that you are not supposed to touch this money before a certain age. If you do, not only will there be income taxes to pay, but also a 10% early withdrawal penalty. These are two moving pieces here: one is the income tax on the distribution and another for the 10% penalty.

Here is a question for you:

Let’s say you can withdraw money from your plan for hardship reasons. Does that mean that the penalty does not apply?

The answer is no. One would think that the two Code sections move in tandem, but they do not.

Candace Elaine ran into this in a recent Tax Court decision.

Candace lived in California, and in 2012 she withdrew $84,000 from her retirement plan. She had lost her job in 2009, and she was trying to support herself and family.

The tax Code applies two requirements to the income taxation of hardship withdrawals:

·        On account of an immediate and heavy financial need, and

·        Any amount withdrawn is limited to actual need

An “immediate and heavy financial need” would include monies needed for medical expenses or to avoid foreclosure. In addition, one is not allowed to withdraw $20,000 if the need is only $12,000, with the intention of using the excess for other purposes. 

The plan custodian is the watchman for these two requirements. The custodian is to obtain reasonable assurance of need and inquire whether other financial resources exist. This is a role above and beyond routine administration, and consequently many plans simply do not offer hardship withdrawals.

Candace met those requirements and her plan allowed withdrawals. She reported and paid income tax on the $84,000, but she did not pay the 10% penalty.

The IRS bounced her return. Off to Tax Court they went, where Candace represented herself.

Her argument was simple: I received a hardship distribution. There is an exemption for hardship.

The IRS said that there was not. And in the spirit of unemployed taxpayers trying to support their family, the IRS assessed a penalty on top of the 10% chop.

The Court pointed several exceptions to the 10% early withdrawal penalty, including:

·        Separation from service

·        Disability

·        Deductible medical expenses

·        Health insurance premiums while unemployed

·        Higher education

·        First time purchase of a principal residence

There isn’t one for hardship, though.

Meaning that Candace owed the 10% penalty.

The Court did note that the misunderstanding on the 10% is widespread and refused to assess the IRS’ second penalty.

Why did Candace not just borrow the money from her 401(k) and avoid the issue? Because she had been let go, and you have to be employed in order to take a plan loan.

What if she had rolled the money into an IRA?

IRAs are not allowed to make loans, even to you. The only way you can get money out of an IRA is to take a distribution. This is what sets up the ROBs (Roll-Over as Business Start-Up) as a tax issue, for example.

Candace was stuck with the penalty.

Using An Annuity To Teach Tax

I intend someday to return to college and teach tax. It would be an adjunct position, as I have no intention of taking up another full-time job after this. One tax CPA career is enough.

I have previously taught accounting but not tax. There is some order to accounting: debits and credits, recording transactions and reconciling accounts. Tax and accounting may be siblings, but the tax Code does not purport to show anyone’s net income according to “generally accepted accounting principles.” It may, mind you, but that would be a coincidence.

Sometimes there are jagged edges to tax accounting. Have Johnson & Johnson issue financial statements pursuant to the tax Code and they would likely find themselves in front of the SEC.   

Let's say you are taking your first tax course. The syllabus includes:

·        What is income?

·        What is deductible?

·        Why doesn’t the answer make sense?

I am looking at Tobias v Commissioner. I give the taxpayers credit, as they were thinking outside the box. They knew they hadn’t made any money, irrespective of what the IRS said.

Edward Tobias was an attorney and kept an inactive CPA license. His wife was a school administrator. They had bought a variable annuity in 2003 for almost $230,000. In order to free up the cash, they sold stock at a loss of approximately $158,000. They put another $346,000 into the annuity over the years.

Fast forward to 2010. They withdrew $525,000 to buy and improve a residence. At that point in time, the deferred income (that is, the inside buildup) in the annuity policy was approximately $186,000. They insurance company sent them a Form 1099 for $186,000.

But they left the $186,000 off their 2010 tax return. They did attach an explanation, however:

The … account was funded with after-tax funds and all withdrawals have been made prior to annuitization. Accordingly, any potential gains should be applied to the prior capital loss carryforward, which is approximately $148,000. Additionally, this account has not recouped losses incurred in prior years and has incurred substantial withdrawal penalties; the calculation made by … is incorrect and is contested.”

You know the IRS was going to match this up.

The Tobias’ had a remaining capital loss of $148,000 from stock they sold to buy the annuity. In addition they had already put approximately $576,000 into the annuity, an amount less than the withdrawal. They were just getting their money back, even without taking that capital loss into consideration. 

The IRS on the other hand said they had $186,000 in income. The IRS also wanted an early distribution penalty of almost $19,000.

Who is right?

When the Tobias’ withdrew $525,000, they took deferred income with it. This is the “income first” rule of Code Section 72(e), and the rule has been there a long time. It says that – upon taking money from an annuity – the inside income is the first thing to come out. Like the fable of the frog and scorpion, that is what annuities do.

What about the $148,000 capital loss? A capital loss has a separate set of rules. Capital losses offset capital gains dollar-for-dollar. Past that they offset non-capital-gain income up to $3,000 per year. Annuity income however is not capital gain income, so we are stuck at $3,000.

But the economics were interrelated, argued the Tobias’. They sold the stock to buy the annuity. The loss on that should offset the income from the annuity, right?

No, not right.

When these transactions hit the tax return, each took on its own tax attribute. One attribute went to house Gryffindor, another to house Hufflepuff. They are all in Hogwarts, but they have been separated by the tax Sorting Hat. You cannot just mix them together - unless the Code says you can mix them together. Unfortunately, the Code does not say that.

So you have the odd result that the Tobias’ owed tax and penalty on more money than they made from the deal.

The answer makes sense to a tax guy.

It may just be a bit hard to teach.