Even small improvements can reduce revenue loss
The Treasury Inspector General for Tax Administration (TIGTA) has recommended a number of actions that can be taken to further improve the strategy for addressing excess IRA contributions. Using information from tax year 2011 Forms 5498, IRA Contribution Information, the TIGTA audit found that 57,484 individuals potentially made $125,432,255 in improper IRA contributions because of lack of compensation. It also calculated that the unreported six percent excise tax on each individual’s excess contribution totaled $7,525,935.
The U.S. Government Accountability Office estimates that 43 million individuals had IRAs in tax year 2011 with a fair market value of $5.2 trillion. The tax laws limit the amount that individuals can contribute to IRAs in a tax year, and any individual noncompliance with the excess IRA contribution rules results in a revenue loss to the Treasury. The IRS has previously estimated that as much as $4.2 billion of the tax gap can be attributed to underreported retirement income. Given the enormity of the tax gap, even small improvements in identifying noncompliance could reduce revenue losses.
TIGTA previously performed audits—in fiscal years 2008 and 2010—to determine whether the IRS has an effective strategy to identify and address excess IRA contributions. In response to recommendations from these audits, the IRS developed a broad-based strategy that focuses on educating individuals and tax preparers about the IRA rules and notifying individuals when they have potentially exceeded the IRA contribution limits.
TIGTA’s most recent audit looked at the actions that the IRS has taken to address previous audit recommendations and found that improvements could be made.
The audit found that, while the IRS developed educational material for individuals and tax preparers, it did not develop—or even consider—educational materials for IRA custodians. In analyzing tax year 2011 Forms 5498 for excess contributions, TIGTA determined that approximately seven percent (834,000) of the 11.9 million 2011 Forms 5498 filed by IRA custodians appeared to be inaccurate. The audit found instances in which Traditional and Roth IRA information from the same custodian was reported on a single Form 5498, and other instances in which IRA custodians reported rollovers from other IRAs in the IRA contribution box on Form 5498. TIGTA also noted that individuals responding to IRS notices to address retirement plan noncompliance sometimes reported that Forms 5498 received from IRA custodians were inaccurate and contained incorrect contribution amounts.
These types of information reporting errors by IRA custodians make it more difficult for the IRS to determine potential excess contributions. This could result in the IRS erroneously contacting compliant individuals who did not make excess contributions, while overlooking noncompliant individuals who did make excess IRA contributions.
The IRS also implemented processes to send soft notices to a sampling of individuals whom the IRS identified as having potentially made excess IRA contributions in tax year 2011. These soft notices do not require the individual to pay additional tax, furnish additional documentation, or even respond to the IRS. They serve to educate the individual that he may have made an excess IRA contribution and encourage self-correction. But while they encourage individuals to file an amended return if appropriate, it is not required. The IRS chose to implement this soft notice process because the costs associated with more robust enforcement efforts would outweigh the benefits.
The IRS evaluation of the tax year 2011 soft notice sampling results is not complete. However, the TIGTA audit found that while the IRS has made strides in identifying and notifying individuals who have potentially made excess IRA contributions, the methodology used for identifying noncomplying individuals could be improved.
For tax year 2011, the IRS identified 22,634 individuals with potential excess IRA contributions, and selected a sampling of 1,502 individuals to receive the soft notice. But when creating the criteria to identify potential excess IRA contributions, the IRS did not consider whether the individuals had compensation. By including compensation in the criteria, the TIGTA audit determined that more than 57,000 individuals contributed more than $125 million in IRA contributions in tax year 2011 that are potentially ineligible because the individuals did not report any eligible compensation to the IRS.
TIGTA Audit Recommendations
TIGTA recommended that the IRS develop educational materials for IRA custodian to inform them of common mistakes made on information returns and the importance of submitting accurate information returns. They also recommended that the IRS identify a more complete and accurate universe of individuals who potentially made excess IRA contributions from which to select potentially productive cases.
IRS Response to TIGTA Recommendations
In responding to TIGTA’s recommendations, the IRS indicated that it will continue to inform IRA custodians of issues and errors that affect IRA administration from a tax perspective. The IRS will use existing communication vehicles, including the IRS’ Employee Plans News, to address and reduce common information reporting errors. The IRS also agreed that the next logical step is to expand the soft notice program by increasing the scope of notice recipients. They also indicated that they will continue to evaluate the pilot notice program from a budget perspective.
It remains to be seen how quickly the IRS expands the soft notice process, given current budget constraints, and the fact that the average potential excise tax deficiency associated with excess IRA contributions is only $131 per taxpayer. What is certain is that policymakers are focused on closing the tax gap as one way to shrink the budget deficit. IRS Commissioner Doug Shulman, speaking to the Tax Executives Institute in late 2008, acknowledged that the IRS cannot audit its way to full compliance, and that information reporting will be the key to future success in reducing the tax gap. With $4.2 billion of underreported retirement income, and $5.2 trillion in IRA assets, further scrutiny of reporting IRA transactions is to be expected.