Q:

Subject: Inherited IRA 50% Penalty

 

Dear Kerry Kerstetter,

Your web page and blog are great!

I have searched the web high and low for an answer to my question about Inherited IRAs, and can't find the answer anywhere. Maybe it's appropriate for your blog, as many people are probably in the same situation:

I inherited an IRA from my mother, who died in 1996.  Web pages tell me I should have begun taking out yearly minimum distributions in 1997, or I should have cashed out the whole account by the end of 2001.  If not, there is a 50% penalty on what I should have taken out.

The problem is, I didn't know any of this until now.

So what to do now in 2005?  No web page anywhere has the answer!

I guess the strictly correct answer according to the IRS is that I must file amended returns for every year from 1997 to 2004 and report the under-withdrawal and pay the 50% penalty, and calculate interest, and late payment fees.  But amending 8 years of tax returns would drive me crazy, and I would prefer to just forfeit the whole account instead!

So should I just start taking minimum distributions in 2005 and hope the past returns don't get audited?  Or is there another solution?

Thanks for any help, and if there is a fee for your answer, I would be glad to pay.

A:

You do really need to work with a qualified tax pro to handle the several issues that this situation raises for you.

Going back and amending most of those older years' tax returns isn't even a valid option because of the three year statute of limitations barring any changes to any 1040 that has been filed more than three years ago.  Even filing 1040Xs for the three open years would be dangerous for you.  If you've been reading my blog, you know that the coast still isn't clear from the risk of IRS initiating full-blown audits of taxpayers who file amended returns.

The old adage that "ignorance of the law is no excuse" is least appropriate in the area of tax law.  Our convoluted mish-mash of a tax system is so confusing to absolutely everybody that penalties are routinely waived by IRS for those persons who can make the case that the oversight was unintentional. 

Technically, somebody involved with the transfer of the IRA to your name (such as the account custodian or probate attorney) should have notified you of the requirement to start withdrawals from the account by the end of 1997, as should have your personal tax preparer, if you had told him/her about the inheritance.  Since nobody obviously told you about that requirement, you would probably be best off starting the withdrawal plan in 2005.  You should attach an explanation of the circumstances creating the delay to your 1040.

This obviously isn't the only way in which to handle this situation for you.  As I said earlier, you should consult with a tax pro, who may either endorse this strategy or advise another option, especially if there are other pertinent details that you didn't mention in your email to me.

Good luck.  I hope this helps.

Kerry Kerstetter

Follow-up:

Dear Kerry,

Thank you very much for your informative answer.

The only thing I didn't mention was that on the Form 5498 I receive each year from Fidelity, it is always written in Bold print in Box 11:

"Required Minimum Distribution for 2004 - NO".

This should certainly help my case for pleading ignorance of the required distribution for previous years.  I will attach a copy of Form 5498 and an explanation to my 2005 return (and do the required distribution for 2005).

I also noticed that on Form 5329 for reporting excess accumulations, you can only pay a penalty for 2005.  The IRS doesn't make it easy to pay the 50% penalty for previous years.

Just curious why there is a lower audit rate for returns with lots of explanatory attachments, as you say on your web page.  Off hand you would think extra attachments would draw more attention to a return.  Maybe it makes the IRS think you are not hiding anything if you explain everything?

Reply:

While the lack of a check mark or a YES in Box 11 on the 5498 will help you defend against any IRS penalties, it is not by itself a 100% guarantee as the instructions for that box say on the back of the 5498 form. 

Box 11. If the box is checked, you must take a required minimum distribution (RMD) for 2006. An RMD may be required even if the box is not checked. The amount, or offer to compute the amount, and date of the RMD will be furnished to you by January 31 either on Form 5498 (in the blank box to the left of box 10) or in a separate statement. If you do not take the RMD for 2006, you are subject to a 50% excise tax on the amount not distributed. See Pub. 590 for details.

In regard to attaching explanatory documents to tax returns, it helps to understand how IRS processes the returns.  They enter the information from the returns into their computers and then run several tests on the data to check the accuracy.  They match against third party information documents, such as W-2s, 1099s and 1098s and kick the return out if there is a discrepancy. 

They also match up dependent info to ensure that they are valid SSNs and haven't been claimed on another tax return.  Again, discrepancies cause the return to be kicked out.

The tax return data are run through the basic audit selection process which uses the super top secret DIF (discriminant index function) score, which measures such things as expenses in relation to income and occupation.        If the DIF Score comes out high, the return is kicked out.

Here is the critical point.  When a tax return is kicked out by the IRS computer, a human IRS employee will look at the actual paper return if one is available (not e-filed) and go through it to see if there is an explanation for the discrepancy or other abnormality.  If the explanation appears to be valid, the return is processed as filed and the taxpayer never has a problem. 

On the other hand, if there is not adequate explanatory info attached, the item in question is automatically disallowed or the return is sent out to the field for a full blown examination.  While one item may have triggered the selection for audit, the actual exam will cover many more things on the return while they are at it.  It opens a can of worms that cannot be closed.

This is not just a theory.  Because of my very high billing rate and very exclusive clientele, a high percentage of the tax returns I prepare have the kinds of unusual things that would automatically trigger IRS audits if there weren't explanatory information attached.  Many of the tax returns we assemble are an inch thick, even when printing on both sides of the paper.  That extra info has kept the number of returns chosen for audit at a small fraction of the
national average.

I have had arguments over this issue with other tax preparers for decades.  I still firmly believe that any preparer who refuses to attach the additional explanatory information to tax returns is intentionally trying to drum up additional off-season billable work by implicitly asking for an audit.  Any preparer who doesn't have the experience to know what kinds of things would require this additional explanation is probably too green to be trusted.

I hope this clarifies this point for you.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 11/29/2005 08:48:00 PM Send this post: