Failure of substantailly equal payments

[Fred Payne]

Client has an IRA from which she is withdrawing $4,800 monthly to avoid 10% premature distribution penalty. Four years into the withdrawal program, one of the funds from which sytematic withdrawals were coming from was depleted, leaving her $900 short for that month. Broker switched liquidations to a different fund for the next and subsequent months, but never made up the $900 shortfall. Consequently, her year 2003 distribution was short.

CPA is saying she's subject retroactively to the 10% penalty plus interest.

What has been others experience in trying to get relief from the penalty? With distributions at $55,600 annually for 4 years, the penalty will be in excess of $22K for missing $900 in distributions.

[E as in ERISA]

What method was used to calculate the payment. Would the RMD method have produced a smaller distribution, especially with changes in value and changes in the mortality tables, etc.? I don't recall what the timing is to elect the method, etc. But it might be worth checking. The IRS issued a ruling on this last year I believe.

[E as in ERISA]

The ruling I'm thinking of is Rev Rul 2002-62. You might want to see if it helps.

[mbozek]

What is the risk that the IRS will ever discover that the 2003 payment was $900 short? Why ask the IRS anything given the remotness of the IRS discovering that the payment is short? Maybe the client needs another tax advisor.

[QDROphile]

It is so terribly bothersome, expensive and messy to to comply with the law. Who even wants to hear about it?

[Guest Harry O]

QDROphile -

If she has already filed her 2003 return in good faith and did not report the shortfall, there is no requirement to file an amended return. I agree with mbozek.

[Guest Pensions in Paradise]

No disrepect to Mbozek or Harry O, but I would disregard what they said and retain proper counsel to resolve this situation. Unless the client doesn't mind making a $22,000 gamble that the IRS won't find out about it.

[mbozek]

P: With "All Due Respect" the client has already rolled the dice by underpaying the distribution by $900. Unless the client can reduce the mrd under RR 2002-62 there is a penalty tax due. The client has to weigh the risk of paying the IRS 22k vs the remoteness of an audit by the IRS which will discover the shortfall.

[Appleby]

Fred,

Do you recall whether the payments began in mid-year or at the beginning of the year? If the client is not on a calendar year schedule, maybe there is still time to distribute the additional $900. For instance, if the distributions for the first year started in July and the individual received $4,800 each month since then, technically, the individual could be on a June/July fiscal year, with the required total for the year to be distributed by June 30.

[Guest FormsRmylife]

Where did the 22k come from that is making some want to play audit roullete?

4974(a) GENERAL RULE. --If the amount distributed during the taxable year of the payee under any qualified retirement plan or any eligible deferred compensation plan (as defined in section 457(b)) is less than the minimum required distribution for such taxable year, there is hereby imposed a tax equal to 50 percent of the amount by which such minimum required distribution exceeds the actual amount distributed during the taxable year. The tax imposed by this section shall be paid by the payee.

So $10,800 ($900 * 12) is the shortfall. The tax is 50% or $5,400.

Then the IRS may waive per 1.4974-2, Q&A8(a):

Q-7. Are there any circumstances when the excise tax under section 4974 for a taxable year may be waived?

A-7. (a) Reasonable cause. The tax under section 4974(a) may be waived if the payee described in section 4974(a) establishes to the satisfaction of the Commissioner the following --

(1) The shortfall described in section 4974(a) in the amount distributed in any taxable year was due to reasonable error; and

(2) Reasonable steps are being taken to remedy the shortfall.

[Appleby]

FormsRmylife,

You cite refers to the waiver when an individual fails to distribute the RMD amount.

Are you saying this also applies to substantially equal periodic payments -under 72(t)?

[No Name]

Maybe there's wiggle room in the definition of "substantially equal". The variance from the schedule was 1.5%.

[Guest RobO]

Another alternative might be asking the broker to work through the fund company/custodian to liquidate $900 "as of" a date in 2003. The broker may have some responsibility to ensure that the systematic withdrawal runs smoothly, and quite often custodians are willing to backdate a redemption if they are held harmless or otherwise indemnified by a broker's back office. Assuming they are willing to do so, and issue a corrected 1099R, all the client will have to do is amend their 2003 tax return.....a small hassle, but alot better than risking $22k in penalties.

[jevd]

My understanding is that the 50% penalty applies only to the "underdistributed RMD amount" RMD is only one method for calculating the 72(t) distribution.

The penalty for busting a 72(t) substatntially equal payment is that the amounts from day one are taxed and penalized (with interest) as if they were premature distribution with no exception applying.

2002-62 allows for a one time change to RMD calculation method and there is very little wiggle room if any.

[Guest FormsRmylife]

No, Appleby, I misread the question.

[Fred Payne]

Thank you for the lively discussion.

I first looked to Rev Rul 2002-62. The problem is that using an alternate calulation method will not give the taxpayer the exact dollar amount of distribution that in fact occurred.

Has anyone had any experience in receiving any relief from the penalty in a similar fashion to a relief of penalty from a failed RMD?

[E as in ERISA]

No. But if you actually plan to "play roulette" I would do everything you can to show good faith -- e.g., documenting how the error occurred, distributing the other $900 ASAP, updating procedures to ensure that this won't ever happen again, documenting your analysis of 2002-62 and conclusion that actual payments would have been greater than the amount you would have withdrawn if you had made the switch, etc. It doesn't guarantee abatement of penalties. But it's generally better to wear a "white hat" than a "black hat" into negotiations with the IRS.

[mbozek]

Unlike the 50% mrd excise tax, the IRS has no authority to excuse the 10% penalty under IRC 72(t). See Pub 590 p 51-52. There is nothing the taxpayer can do except wait for the statute of limitations to expire which will be 3 yrs from the date each return is due or until 4/15/07 for the 2003 return.

[Guest Pensions in Paradise]

Although the statute of limitations won't expire because the taxpayer did not declare the excise tax on their return. The IRS could take the position that it was an incomplete return and thus, no statute of limitations.

[Guest Harry O]

No they could not.

[Guest Harry O]

BTW, I have never seen such handwringing in my life. A taxpayer files her tax return believing she received substantially equal payments and thus was exempt from the 10% early distribution tax. She subsequently finds out from her accountant that she was $900 short. There is no way to legitimately correct the error or do have the failure waived. But many posters to this board would have our poor taxpayer file an amended return and fess up the $900 shortfall. For her trouble, she will get a $22,000 bill from the IRS. There is no, repeat no, duty to file an amended return in these circumstances. In addition, we now have someone saying there may be no statute of limitations because the taxpayer omitted $900 of income from her return! I hope our taxpayer eventually found her way to a new tax advisor and didn't read these boards! <g>

[mbozek]

??- the 10% penalty in 72(t) is an additional income tax, not an excise tax, which is reported on the 1040. See instructions to form 5329. Therefore the s/l for the penalty begins when the income tax is filed. I dont know what you mean by an incomplete return.

[Guest Pensions in Paradise]

With regard to those who say you can file an incomplete/false/inaccurate return and hope to escape the tax under a statute of limitation, please see Code section 6501©(1).

[Guest Harry O]

Section 6501© applies where the individual filed a "false or fraudulent return WITH THE INTENT to evade tax." Our situation involves someone who filed the return in good faith believing that she qualified for the substantially equal payment exception. There is no evidence here that she knew she was $900 short at the time she filed.