Hi, Gail-

I found out when I got my taxes done last month that I was supposed to be taking “required distributions” from the IRA I inherited from my mother four years ago (2007).  I understand there’s a big penalty- 50%. 

 

I’ve got two questions: 1- How do I correct this?  2- Is there any way out of the penalty?

 

Thanks,

Brad

 

Dear Brad,

I’ve got good news and….more good news!

 

First of all, a non-spouse beneficiary of either a traditional IRA or a Roth IRA has to take required minimum distributions from the account only if he or she wants to stretch the withdrawals over his life expectancy.  To do so, you must take your first withdrawal by Dec. 31 of the year after the IRA owner died.  The amount you have to take out each year after that is based on the beneficiary’s life expectancy factor (you can find this number here

After you have withdrawn at least the minimum amount for five years, you have to continue to do so.(1)  If, for some reason, you take out too little- or nothing at all- you will get slapped with a 50% penalty.  For instance, if you should have withdrawn $8,000, but forgot, you will be fined $4,000 (half the amount you should have withdrawn).  If the inherited account is a traditional IRA you will also owe income tax on the $8,000. 

On the other hand, if you don’t want to stretch out the withdrawals, you can simply cash out the inherited IRA within 5 years after the account owner died. By doing this, there is no annual withdrawal requirement and no 50% penalty.  The downside is that those assets are no longer shielded from taxes.

The advantage of taking out the smallest amount allowed by law each year cannot be over-emphasized. The assets that remain in the IRA have the potential to grow and compound for, perhaps, decade, so the, younger the beneficiary, the greater the impact. 

For example, suppose a $30,000 IRA is left to a 6-years-old granddaughter the year after grandma died.  If we assume the account earns 8% annually and the beneficiary just withdraws the minimum amount over her 75-year life expectancy, her cumulative inheritance would exceed $2.1 million! And, if grandma had converted her IRA to a Roth, every penny her granddaughter receives will be income tax free.

Now Brad, without knowing the value of your mom’s IRA and your age,  it’s impossible to calculate what the impact of just taking out the required minimum distribution (RMD) would be in your case.  However, for the sake of argument, let’s say you’re 45.  According to the IRS Single Life Expectancy Table, you could stretch your withdrawals out nearly 40 years.(2)  That could significantly magnify the total amount of income you receive from your mom’s IRA.

Assuming this is your preference, there’s a relatively easy way to get back on track.  According to Michael J. Jones, a CPA in Monterey, Calif., you can request the 50% penalty be waived by filing Form 5329 with your 1040 federal tax return.  Be prepared to explain: 1why you failed to take your RMD for a specific year and what steps you have taken to remedy the situation.

Here’s a helpful hint: the correct answer to No.1 is not “I didn’t know about it” or “I forgot.” Jones says you need to demonstrate that the shortfall was due to “reasonable error.”  Unfortunately, the IRS does not provide any explanation of this term.  Perhaps you received bad advice or the IRA custodian lost your request (and you have a receipt confirming that you sent it).  Just don’t make up a whopper and expect the IRS to bite., “Do be honest.  Tell the truth.  You’re signing under penalty of perjury,” Jones suggested.

The correct answer to No.2 is that as soon as you realized your mistake, you took the withdrawal and paid the owed income tax. In other words, you should take corrective action before you ask the IRS to give you a break.

Don’t panic if you receive a rejection notice and the IRS slaps you with a bigger tax, says Jones.  “You have the right to appeal.  It’s not hard.”   He says you simply need to write a short letter re-stating why you believe your error was, in fact, “reasonable” and wait for your request to be reviewed by an appeals officer.  “You don’t know unless you ask,” he said.  “I’ve had it happen where… an attorney failed to advise a trustee for six years that she needed to take distributions.”  Although the request for a waiver of the 50% penalty was initially rejected, it was granted on appeal.

Even if you ultimately have to pay a 50% penalty to restore your ability to stretch out the withdrawals from your mom’s IRA, you will only owe it on the distribution you failed to take in 2008. RMDs were suspended last year.  Since they weren’t required, the 50% penalty didn’t apply.

You have until Dec. 31 of this year to take your required withdrawal for 2010.  

1. You can always withdraw more than the minimum, including the entire balance remaining in the IRA.  At that point, there are no more required distributions.

2. The life expectancy factor of a 45-year old is 38.8.

 

 

 

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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