Taxpayers miss out on tax benefits each year because they are unfamiliar with the tax laws or because they make mistakes when filing their returns. For example, you may pay taxes on amounts that should be tax free or pay excise taxes on distributions when you are actually entitled to waive those excise taxes. In this article, we highlight some of the tax benefits you should know about and tell you how to take advantage of them.
Basis, also referred to as after-tax balances, accrue in retirement accounts from nondeductible contributions and rollovers of after-tax amounts to IRAs. Distributions of basis amounts are supposed to be tax free. However, if you fail to track these amounts, you could end up paying the IRS taxes on them, resulting in double taxation. Furthermore, if you fail to file IRS Form 8606 (Nondeductible IRAs) for the year, you may owe the IRS a penalty of $50, unless you can show reasonable cause for the failure.
Jack made a rollover contribution of $100,000 from his 401(k) plan to his Traditional IRA. A total of $25,000 represents contributions Jack made to his 401(k) account on an after-tax basis, which means distributions of these amounts should be tax free when distributed from his IRA. However, Jack failed to file Form 8606 to report and track the amount. Jack withdrew his IRA balance over a five-year period and included the entire amount as taxable income for the five years. Over this period, Jack paid taxes on $25,000 that were eligible for tax-free treatment. Had Jack filed Form 8606 for the year the rollover occurred, and for any subsequent year in which he made distributions from his IRA, he would not have paid taxes on the $25,000 that represented his after-tax balance.
I. Once you make a nondeductible contribution or roll over after-tax amounts to any of your Traditional, SEP or SIMPLE IRA, any subsequent distributions from any of your Traditional, SEP or SIMPLE IRAs will include a prorated amount of pretax and post-tax assets, as these IRAs are aggregated for the purposes of determining the taxable amount of any distributions.
II. If you have multiple Traditional, SEP and/or SIMPLE IRAs with different primary beneficiaries, you may want to maintain a separate Form 8606 for each IRA. This would allow each beneficiary to determine the basis of his or her inherited IRA and file any required Form 8606 accordingly.
Pretax retirement assets that are not distributed before the retirement account owner's death are not taxable to the deceased retirement account owner. Instead, they are included in the beneficiary's taxable income for the year distributed. However, such amounts may be included in the decedent's estate and subject to estate tax. If the decedent's estate filed IRS Form 706 (United States Estate [and Generation-Skipping Transfer] Tax Return), the amount of estate tax is reflected thereon, and the beneficiary may be eligible for a federal tax deduction for the amount of estate taxes reflected on Form 706. This deduction is referred to as Income in Respect of Decedent (IRD), and it is one of the most significant deductions available for inherited assets. Unfortunately, it is also one of the deductions that taxpayers most often miss.
Tax experts opine that failure to claim the IRD could result in a tax rate of more than 80% on the inherited amount. Of course, this 80% is not paid by just the beneficiary, but rather it is a combination of the estate taxes paid by the decedent's estate and the federal and state taxes paid by the beneficiary. IRD is claimed as an itemized estate tax deduction on IRS Schedule A, and it is not subject to the 2% of adjusted gross income limit that applies to miscellaneous deductions. If you do not itemize your deduction, you will not receive the IRD deduction.
An in-depth explanation of IRD and how it works is beyond the scope of this article. However, if you inherited retirement plan assets and either took distribution of those assets during the last three years or still have balances in your inherited retirement accounts, be sure to talk to a retirement plan expert to determine whether you are eligible to claim the deduction for the IRD.
Distributions from your retirement accounts before you reach age 59½ are subject to a 10% excise tax (early-distribution penalty), unless an exception applies. Your IRA custodian or plan administrator (the payor) will generally indicate that one of these exceptions applies to your distribution in Box 7 of your 1099-R, but may not do so in all cases for reasons that include the following:
If you are eligible for any of the exceptions and this was not indicated on your Form 1099-R, you may rectify this by filing IRS Form 5329.
Waiving the Excess Accumulation Tax
Certain distributions must be completed by the end of the year in order to avoid penalties. For instance, except for the year you reach age 70½, when you can defer your required minimum distribution (RMD) until April 1 of the next year, your RMD must be distributed by the end of the calendar year or you will owe the IRS an excess-accumulation penalty tax of 50% of the RMD shortfall. However, if the failure to distribute your RMD by the deadline is due to a reasonable error, you may request a waiver of the penalty by distributing the amount and writing an explanation to the IRS.
Getting Back on Track with Busted SEPPs
One of the exceptions to the 10% early-distribution excise tax is taking distributions as part of a substantially equal periodic payment (SEPP). However, if you failed to distribute the required amount by the end of the year, that may be considered a modification, and your SEPP program could be busted, which means that you would be required to pay all the excise taxes that were waived under the program, plus interest, and would not be able to continue that SEPP program. In such a situation, your options include the following:
An example of how the IRS could respond to the second option is private letter ruling (PLR) 200503036. The taxpayer who applied for this PLR provided instructions to his financial institution to distribute the SEPP amount before the end of the year. However, the amount was not distributed by year-end due to the financial institution's error, but was instead distributed at the beginning of the following year. After reviewing the explanation of the facts and circumstances provided, the IRS agreed that the missed payment would not be considered a modification, and no penalties were assessed.
A PLR cannot be cited as precedent or legal reference, but it gives a good idea of how the IRS would respond to issues with similar fact patterns.
The IRS allows the taxpayer to file an amended tax return (IRS Form 1040X) to receive a tax credit or refund for a given year within three years after the date the individual files the tax return for that year, or two years after the date on which the taxpayer pays any taxes for that year, whichever is later. Therefore, if the error is detected early enough, you may file amended tax returns for any refund due for the applicable years. Applicable tax forms, for instance Form 8606, can be attached to Form 1040X or can be filed independently. Check with a tax professional to be sure.
Remember these two key points and you should be in good shape: being aware of tax benefits can result in significant savings, and missed benefits can be recouped if detected early. Understanding tax rules can be very challenging, especially if you don't have the time to study these rules and understand how they may apply to you. If you seek the help of a tax professional who is also a retirement plan expert to handle your retirement plan affairs, you'll ensure that you receive all the tax benefits that apply to your retirement assets, including those that you inherit.
All the forms mentioned in this article are available at www.irs.gov.