Treasury audit identifies significant noncompliance with RMD rules
A recent audit by the Treasury Inspector General for Tax Administration (TIGTA) has identified nearly 639,000 taxpayers with IRAs worth $40.4 billion who may not have taken required minimum distributions (RMDs) from IRAs in tax year 2012. The TIGTA is recommending that a number of actions be taken to ensure that taxpayers are complying with the rules for taking IRA RMDs.
These findings are significant, as the Investment Company Institute reports that IRAs, which represent more than one-quarter of total U.S. retirement market assets, held $5.4 trillion in assets at the end of the fourth quarter of 2012. Taxpayers are required to begin withdrawing a minimum amount from their Traditional IRAs when they reach age 70½. When they fail to take these RMDs, the Treasury loses revenue because assets that should be taxed remain sheltered.
The IRS has previously estimated that as much as $4.2 billion of the tax gap—the difference between what taxpayers should pay and what they ultimately pay on a timely basis—can be attributed to underreported retirement income. Given the enormity of the tax gap, even small improvements in identifying noncompliance could reduce revenue losses.
The TIGTA previously performed audits—in fiscal years 2008 and 2010—and found that the IRS does not ensure that taxpayers are complying with the RMD rules for IRAs. The TIGTA recommended that that the IRS use information from Forms 5498, IRA Contribution Information, to identify taxpayers who are subject to RMDs and compare this to subsequent tax returns to determine whether distributions were reported. In response to recommendations from these prior audits, the IRS developed a broad-based strategy that focuses on educating tax preparers and individuals about the IRA rules and notifying potentially noncompliant taxpayers of the minimum distribution requirement.
The TIGTA’s most recent audit, which was conducted May through October, 2014, reviewed the IRS’ actions to determine whether IRS processes provide reasonable assurances that taxpayers are complying with the provisions for taking IRA RMDs. They found that significant improvements were made from prior audits, but that the IRS could take additional steps to improve its strategy to ensure taxpayer compliance.
The 2014 audit found that, while the IRS developed educational material for taxpayers and tax preparers, taxpayers required to take RMDs could benefit from more direct methods of communication, such as informing them of the requirement to take RMDs when they reach age 70½. The TIGTA believes that direct communication with taxpayers would increase awareness of the requirement and avoid the 50 percent excess accumulation penalty tax that is imposed on taxpayers who fail to take their RMDs. Such an approach would also be consistent with congressional interest in educating taxpayers with respect to IRA provisions and not unreasonably penalizing them for innocent mistakes.
As noted, the TIGTA’s analysis found nearly 639,000 taxpayers with IRAs worth more than $40.4 billion who may not have taken required distributions in tax year 2012. While there is no way to determine why taxpayers did not take their RMDs, the IRS received feedback from some taxpayers that they were unaware of the requirement.
Nearly 6,500 taxpayers submitted Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to self-report that they failed to take their RMD and pay the 50 percent excess accumulation penalty tax associated with the failure. The IRS collected excise taxes totaling $6.2 million with nearly 3,000 of these taxpayers paying an excise tax of at least $500. This is significant because it means that their RMDs totaled at least $1,000. Of the taxpayers who reported that they failed to take RMDs, 335 taxpayers received a full abatement of the excise tax because they acknowledged the mistake and submitted a request for abatement of the excise tax.
The audit also found that the IRS implemented processes to send soft notices to noncompliant taxpayers. The soft notice advises taxpayers that they may not have taken a required distribution from their IRA and need to take it, or they could be subject to more detailed review by the IRS.
The IRS identified 10,817 potential noncompliant taxpayers by analyzing information submitted on Form 5498 with tax returns filed for 2011 and 2012, that showed no corresponding IRA distribution reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. From this group, the IRS sent 1,498 soft notices to taxpayers who may not have taken their RMDs in 2011 and 2012, choosing from those taxpayers who would potentially have the greatest tax consequence.
The IRS’ evaluation of the soft notice sample results is not complete. However, the TIGTA audit found that the methodology used for identifying noncompliant taxpayers could be improved. The audit report states that while the IRS identified 10,817 potential noncompliant taxpayers and selected a sample of 1,498 taxpayers to receive the soft notice, it could have identified 623,000 more potentially noncompliant taxpayers by refining its criteria to mirror the criteria used by the TIGTA. The TIGTA’s analysis of two statistically valid random samples of 150 taxpayers each determined that 28 percent of the potentially noncompliant taxpayers with Traditional IRAs either made errors in calculating their distribution amount or did not take the distribution.
TIGTA Recommendations and IRS Response
The TIGTA recommended that the IRS develop two direct notifications for taxpayers who may be required to take an RMD—one for taxpayers age 70½ and older with Traditional IRAs and another for estates of deceased taxpayers—to inform them of their tax obligations related to RMDs. It also recommended that if the IRS expands the soft notice program, it should consider modifying the methodology used to identify potential noncompliant taxpayers and include taxpayers with simplified employee pension (SEP) and savings incentive match plan for employees of small employers (SIMPLE) IRAs. The TIGTA estimates that the IRS could collect more than $103.6 million in additional taxes if it expanded and enhanced the criteria for identifying noncompliant taxpayers and an additional $25.7 million in additional taxes by including taxpayers with SEP and SIMPLE IRAs.
In responding to the TIGTA’s recommendations, the IRS indicated that implementing direct communication to taxpayers age 70½ and older would help educate these taxpayers with respect to the RMD rules. The IRS, however, disagreed with the recommendation to notify the estates of deceased owners, arguing that beneficiaries of inherited IRAs are not known to the IRS. The IRS also indicated that in December 2014, taxpayers with SEP and SIMPLE IRAs were added to the soft notice sample population, which informs these taxpayers of potential RMD obligations. Having agreed in part with the recommendations, the IRS then informed the TIGTA that because of budgetary constraints it does not intend to implement a direct communication program at this time and will not expand the soft notice pilot program.
Going forward, it remains to be seen how the IRS will ensure that taxpayers are complying with the provisions for taking RMDs from their IRAs. With $4.2 billion of underreported retirement income and $5.4 trillion in IRA assets, further scrutiny of taxpayer compliance with the RMD rules is to be expected.
