Year-in and year-out, some of our most frequently asked questions involve IRA Required Minimum Distributions (RMDs).
Every producer has this experience at least once. An age 70-plus client tells you that, through an oversight, RMDs were not taken from the person’s IRA beginning at age 70-1/2. You are aware Code Section 4974(a) imposes a severe penalty – 50% – on missed distributions. What should the client do?
According to the IRS, an under-distribution of an RMD from an IRA is to be reported on Form 5329 as an attachment to Form 1040. Form 5329 is a form for reporting penalty taxes, so the taxpayer would report the underpayment and assess the penalty tax of 50% of the underpayment and then carry the penalty to the front page of Form 1040.
Fortunately, the IRS can waive the penalty if the client establishes to the IRS’s satisfaction that the under-distribution was due to reasonable error and reasonable steps are being taken to remedy the shortfall (that is, the RMD was taken upon discovery).
In prior years, IRS Publication 590, “Individual Retirement Arrangements (IRAs)”, stated the procedure for requesting a waiver was for the taxpayer to file an amended return for each deficient year, along with Form 5329 “Additional Taxes Attributable To Qualified Retirement Plans (Including IRAs), Annuities and Modified Endowment Contracts.” The taxpayer would pay the excise tax, and attach an explanation why the excise tax should be waived. The IRS would then refund the excise tax if it granted the taxpayer’s request and waives the penalty.
The instructions to Form 5329 for 2006 no longer demand that the excise tax be paid first and then a refund requested. The instructions now simply say “If you believe you qualify for this relief, file Form 5329 and attach a letter of explanation.”
So, for 2006 missed distributions, the client should make the missed distribution immediately, report it on Form 5329, attach a letter of explanation, and hope the IRS is lenient. Of course, if the IRS does not waive the penalty, the extra taxes will have to be paid. From feedback we receive, it appears the IRS is generally lenient.
Pre-2006 Missed Distributions
In the case of missed distributions for years in which a tax return has already been filed, an additional issue comes into play; namely does the taxpayer want to file amended returns? Here are some alternative courses of action. We do not recommend any of these, but merely list them for discussion with the client.
Alternative # 1 – Do Nothing
Strange as it may seem, nothing in the Tax Code or Regulations requires a taxpayer to file an amended return upon discovery of a prior error. Code Section 6011 generally requires a taxpayer to file an income tax return for each taxable year, but this section refers only to the original return and not an amended return.
Regulations under Code Sections 451 and 461 state the taxpayer should file an amended return if income was not included or a deduction improperly taken in a prior tax year. Note the regulations state a taxpayer should file an amended return, not must file an amended return. IRS Publication 17, “Your Federal Income Taxes for Individuals”, contains a similar instruction. Accordingly, most tax commentators hold a taxpayer has no legal duty to file an amended return upon discovery of an error.
If the taxpayer doesn’t file an amended return and pay the excise tax, interest and penalties will continue to grow until such time, if ever, the IRS discovers the error.
Another law that may encourage some taxpayers to act rather than do nothing is the Proposed Regulations to Code Section 408. The regulations state an IRA won’t lose its tax-exempt status for “isolated instances” of a taxpayer’s failure to take minimum distributions, but a pattern or regular practice of failing to meet the distribution requirements may cause the IRA to be disqualified.
Alternative # 2 – File Amended Returns and Ask The Excise Tax Be Waived
Code Section 4974(d) allows the IRS to waive the 50% excise tax if the taxpayer demonstrates: (1) the missed distribution was due to reasonable error, and (2) appropriate steps are being taken to remedy the situation.
According to IRS Publication 590, “Individual Retirement Arrangements (IRAs)”, here’s the procedure for requesting a waiver: The taxpayer files an amended return for each deficient year, along with Form 5329 “Additional Taxes Attributable to Qualified Retirement Plans (Including IRAs), Annuities and Modified Endowment Contracts.” The taxpayer attaches an explanation why the excise tax should be waived. If IRS grants the taxpayer’s request and waives the penalty, no taxes are due. On the other hand, if the request is denied, the excise tax plus interest will have to be paid.
The obvious disadvantage to this alternative is the taxpayer might have the waiver denied and now has the missed payments “on the record” when they otherwise might have gone undiscovered.
Alternative # 3 – Make Missed Distributions But Don’t File Amended Returns
This solution is often suggested by callers; but it doesn’t appear to resolve the problem. It may be a defense against disqualification of the IRA on the theory the taxpayer voluntarily corrected the missed distributions; therefore, there was only an “isolated instance” rather than a pattern or regular practice. Taking the missed distribution in a subsequent year clearly doesn’t excuse the excise tax; only the IRS can do that using the procedure outlined above.
Furthermore, it’s questionable whether voluntarily making up missed distributions gives the taxpayer much leverage in asking for a waiver of the excise tax if the IRS later discovers the under-distribution on its own.
The taxpayer chooses the alternative he or she feels most comfortable with. Filing amended returns and requesting a waiver without question resolves the problem. Or course, many taxpayers will resist this alternative because of the bother and uncertainty.
Voluntarily making up the missed distributions but not filing amended returns is seen as a compromise between the two alternatives. It may serve as a defense against disqualification, but does nothing to alleviate the penalty tax.
Doing nothing is the easiest solution, but the hazard is severe penalties if discovered, plus possible disqualification of the IRA. Under every alternative the taxpayer should start taking the currently required IRA distributions now!
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