Tax-deferred accounts have long been a boon to savers, allowing them to earn additional growth on top of the growth without Uncle Sam taking a share. But tax-deferred doesn’t mean tax-free, and sooner or later, Uncle Sam will eventually take his share, since each and every retirement account is subject to Required Minimum Distribution (RMD) rules at some point (even Roth accounts, after the death of the original owner!).
Unfortunately, though, the RMD rules can be maddeningly complicated, making it easy for taxpayers to make a mistake by taking a smaller-than-required distribution, taking a distribution from the wrong account (or even the wrong type of account), or (worse yet) missing a distribution altogether. In fact, mistakes in satisfying RMD obligations are so widespread among retirees that in just 2006 and 2007, over a quarter-million individuals failed to take an RMD from their IRAs alone... not to mention all the other types of tax-preferred accounts out there. And given that RMD rules haven’t changed, it’s not a stretch to assume that the number of missed distributions hasn’t gotten any better… especially given that Baby Boomers have since been retiring in droves and reaching the age 70 ½ threshold when RMDs begin.
The problem, of course, is that, not only does a taxpayer still have to catch up on any of their distributions that were missed (which could end out having adverse tax consequences if a large enough amount has to be taken), but the IRS will impose an additional penalty of a whopping 50% of the amount that was supposed to have been distributed in the first place… even if the mistake was purely unintentional!
The good news, though, is that the IRS isn’t entirely without compassion and understanding (truly!), and has the option to decide to waive that punitive penalty for failing to take an RMD. However, it’s important to note that the onus is on the taxpayer to reach out to the IRS, explain that their mistake was the result of a “reasonable error,” and show how they are taking “reasonable steps” to remedy the shortfall.
Unfortunately, though, the bad news is that, although there is a way to waive the 50% penalty, the means for doing so can be just as confounding as the RMD rules themselves… at least if the taxpayer hopes to have their penalty abated!
The first step towards requesting a waiver for a failed RMD is to take the missed distribution(s) as soon as possible, preferably separately and without any additional taxes withheld (so that the amount deposited into a receiving account exactly matches the shortfall). From there, the taxpayer must (correctly) file the appropriate Form 5329 for each of the years that a distribution mistake was made. The caveat is that there is one line in particular - line 54 - which can easily throw a wrench in the works, as the proper way to request the penalty waiver is to not fill out the line the way it is explained on Form 5329 itself, and instead to mark a request for waiver next to that line instead. And, in addition to that, the taxpayer must also attach a letter explaining the reasonableness of both their error and their corrective measure to the IRS.
In the end, the key point is that, while RMD mistakes are common among owners (and beneficiaries) of tax-preferenced retirement accounts, it’s actually quite likely that the IRS will waive the 50% penalty… but only if the appropriate steps are taken in a timely manner to rectify the error. Because while it may be tempting to “roll the dice” and hope that the IRS doesn’t figure out that a mistake’s been made (and then feign ignorance if/when they discover the error), the reality is that it’s far less likely that the IRS will be as understanding had the taxpayer self-reported the mistake in the first place! Especially since the failure to file a Form 5329 to report (and request a waiver of) the penalty means the statute of limitations itself for the 50% penalty never begins to toll in the first place!
Welcome back to the 134th episode of Financial Advisor Success Podcast!
