Individual Retirement Accounts
Additional IRS Actions Could Help Taxpayers Facing Challenges in Complying with Key Tax Rules
Gao ID: GAO-08-654 August 14, 2008
Individual retirement accounts (IRA) allow individuals to save for retirement in a tax-preferred way. Traditional IRA contributions, subject to certain limitations, can be deducted from taxable earnings and taxes on earnings are deferred until distribution. In contrast, Roth IRA contributions are made after tax and distributions are tax-free. Faced with a myriad of rules covering IRA contributions and distributions, taxpayers may fail to comply with the rules. GAO was asked to (1) provide an overview of key rules and describe how the Internal Revenue Service (IRS) educates taxpayers about these rules, (2) describe what IRS knows about the extent of noncompliance with IRA transactions reported on taxpayer returns, and (3) describe challenges taxpayers face with key rules and some options for strengthening compliance. GAO reviewed IRS documents and compliance data. To identify challenges, GAO interviewed officials from the financial industry and advisor representatives.
Taxpayers face a myriad of tax rules governing contributions to, distributions from, and rollovers between accounts for traditional and Roth IRAs. Both types of IRAs have rules governing eligibility to contribute, and all IRA contributions are subject to an annual limit. For example, eligibility to deduct (from taxable income) contributions to a traditional IRA and to contribute to a Roth IRA depends on taxpayer income and filing status, while coverage by an employer-sponsored retirement plan only affects eligibility for deductible contributions to a traditional IRA. Tax rules for distributions diverge for traditional and Roth IRAs, but both types are generally subject to a 10 percent early withdrawal penalty, with some exceptions. Further, traditional IRA owners over age 70? must take minimum distributions or face a 50 percent penalty on the required distribution amount. Rollovers, where a taxpayer moves money from one account into an IRA account, must be completed within 60 days, or the amounts are taxable and subject to penalty. To assist taxpayers in voluntarily complying with IRA rules, IRS offers special publications and telephone assistance for taxpayers with IRA questions. Even with IRS's service efforts, IRS data show that some taxpayers fail to comply with rules for reporting contribution deductions and taxable distributions from traditional IRAs. IRS's National Research Program showed that nearly 15 percent of taxpayers who took traditional IRA contribution deductions as well as 15 percent of those who took taxable distributions misreported on them on their tax returns in 2001 (the most recent data available). IRS has automated enforcement programs--matching tax returns with information reported by IRA custodians--to detect and correct these types of IRA misreporting. For tax year 2004, IRS assessed additional taxes of $23.2 million for ineligible traditional IRA contribution deductions or exceeding the deduction limits and $61.1 million in taxes and penalties for early withdrawals from traditional IRAs. As partly shown by taxpayer misreporting to IRS, taxpayers face challenges in figuring how much they can contribute, navigating the various distribution rules, and rolling over their IRAs between custodians. For example, according to representatives of financial firms and advisors GAO interviewed, taxpayers may not understand that the annual contribution limit applies across traditional IRAs and Roth IRAs in combination. On the distribution side, interviewees said that older taxpayers make mistakes in determining when they must start distributions and calculating the correct amount. Interviewees identified some options for IRS to clarify guidance, such as for the combined contribution limit rule, or develop tools to help taxpayers, such as a Webbased calculator for required minimum distributions. IRS could explore actions such as requiring additional reporting by custodians or simplifying the required minimum distribution rule to strengthen compliance with this complicated rule. Other options to reduce the complexity of IRA rules, such as eliminating income limits on eligibility, pose trade-offs and could be considered in the context of broader tax reform
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GAO-08-654, Individual Retirement Accounts: Additional IRS Actions Could Help Taxpayers Facing Challenges in Complying with Key Tax Rules
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
August 2008:
Individual Retirement Accounts:
Additional IRS Actions Could Help Taxpayers Facing Challenges in
Complying with Key Tax Rules:
IRA Challenges Facing Taxpayers:
GAO-08-654:
GAO Highlights:
Highlights of GAO-08-654, a report to the Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
Individual retirement accounts (IRA) allow individuals to save for
retirement in a tax-preferred way. Traditional IRA contributions,
subject to certain limitations, can be deducted from taxable earnings
and taxes on earnings are deferred until distribution. In contrast,
Roth IRA contributions are made after tax and distributions are tax-
free. Faced with a myriad of rules covering IRA contributions and
distributions, taxpayers may fail to comply with the rules. GAO was
asked to (1) provide an overview of key rules and describe how the
Internal Revenue Service (IRS) educates taxpayers about these rules,
(2) describe what IRS knows about the extent of noncompliance with IRA
transactions reported on taxpayer returns, and (3) describe challenges
taxpayers face with key rules and some options for strengthening
compliance. GAO reviewed IRS documents and compliance data. To identify
challenges, GAO interviewed officials from the financial industry and
advisor representatives.
What GAO Found:
Taxpayers face a myriad of tax rules governing contributions to,
distributions from, and rollovers between accounts for traditional and
Roth IRAs. Both types of IRAs have rules governing eligibility to
contribute, and all IRA contributions are subject to an annual limit.
For example, eligibility to deduct (from taxable income) contributions
to a traditional IRA and to contribute to a Roth IRA depends on
taxpayer income and filing status, while coverage by an employer-
sponsored retirement plan only affects eligibility for deductible
contributions to a traditional IRA. Tax rules for distributions diverge
for traditional and Roth IRAs, but both types are generally subject to
a 10 percent early withdrawal penalty, with some exceptions. Further,
traditional IRA owners over age 70½ must take minimum distributions or
face a 50 percent penalty on the required distribution amount.
Rollovers, where a taxpayer moves money from one account into an IRA
account, must be completed within 60 days, or the amounts are taxable
and subject to penalty. To assist taxpayers in voluntarily complying
with IRA rules, IRS offers special publications and telephone
assistance for taxpayers with IRA questions.
Even with IRS‘s service efforts, IRS data show that some taxpayers fail
to comply with rules for reporting contribution deductions and taxable
distributions from traditional IRAs. IRS‘s National Research Program
showed that nearly 15 percent of taxpayers who took traditional IRA
contribution deductions as well as 15 percent of those who took taxable
distributions misreported on them on their tax returns in 2001 (the
most recent data available). IRS has automated enforcement
programs”matching tax returns with information reported by IRA
custodians”to detect and correct these types of IRA misreporting. For
tax year 2004, IRS assessed additional taxes of $23.2 million for
ineligible traditional IRA contribution deductions or exceeding the
deduction limits and $61.1 million in taxes and penalties for early
withdrawals from traditional IRAs.
As partly shown by taxpayer misreporting to IRS, taxpayers face
challenges in figuring how much they can contribute, navigating the
various distribution rules, and rolling over their IRAs between
custodians. For example, according to representatives of financial
firms and advisors GAO interviewed, taxpayers may not understand that
the annual contribution limit applies across traditional IRAs and Roth
IRAs in combination. On the distribution side, interviewees said that
older taxpayers make mistakes in determining when they must start
distributions and calculating the correct amount. Interviewees
identified some options for IRS to clarify guidance, such as for the
combined contribution limit rule, or develop tools to help taxpayers,
such as a Web-based calculator for required minimum distributions. IRS
could explore actions such as requiring additional reporting by
custodians or simplifying the required minimum distribution rule to
strengthen compliance with this complicated rule. Other options to
reduce the complexity of IRA rules, such as eliminating income limits
on eligibility, pose trade-offs and could be considered in the context
of broader tax reform.
What GAO Recommends:
To strengthen taxpayer compliance, IRS should clarify guidance on the
combined traditional and Roth contribution limit and pursue options to
improve older taxpayers‘ compliance with the required minimum
distribution rule. IRS agreed to take actions consistent with both
recommendations. Technical comments from the Department of the Treasury
were incorporated as appropriate.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-654]. For more
information, contact Michael Brostek at (202) 512-9110 or
brostekm@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Myriad of Rules Govern IRA Transactions, and IRS Provides Services to
Educate Taxpayers:
IRS Research and Enforcement Data Show Taxpayers Misreport Millions of
Dollars in Traditional IRA Transactions:
Complexity Underlies the Challenges That Taxpayers Face in Complying
with IRA Rules, and Some Options Could Bolster IRS Service While Other
Options Would Require Legislative Change:
Conclusions:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: IRS Forms Used to Report Individual Retirement Account
Information:
Appendix III: Comments from the Internal Revenue Service:
Appendix IV: GAO Contact and Staff Acknowledgments:
Glossary:
Tables:
Table 1: General IRA Rules and Associated Penalties by Transaction
Type:
Table 2: Eligibility for Deduction of Traditional IRA Contributions,
Tax Year 2008:
Table 3: Eligibility for Roth IRA Contributions, Tax Year 2008:
Table 4: Maximum IRA Contribution Limits for IRA Owners by Age, Tax
Years 1975-2008:
Table 5: Total Additional Taxes and Taxpayers Assessed by IRS's
Automated Underreporter Program on Select Contribution and Distribution
Rules for Traditional IRAs, Tax Years 2001-2004:
Table 6: Taxpayer Challenges in Complying with Key IRA Rules:
Figures:
Figure 1: Number of Taxpayers Owning IRAs and Fair Market Value of IRAs
by IRA Type, Tax Year 2004:
Figure 2: Number of Taxpayers Contributing to Traditional and Roth IRAs
by Age, Tax Year 2004:
Figure 3: Illustrative Example of Using Form 1040 with Information
Reporting to Check Taxpayer Compliance with Traditional IRA Rules:
Figure 4: Overview of IRS Automated Enforcement Activities for IRA
Rules:
Abbreviations:
AGI: Adjusted Gross Income:
AUR: Automated Underreporter:
IRA: Individual Retirement Account:
IRSL Internal Revenue Service:
NRP: National Research Program:
SEP: Simplified Employee Pension:
SIMPLE: Savings Incentive Match Plan for Employees:
SOI: Statistics of Income:
TE/GE: Tax Exempt and Government Entities:
TIGTA: Treasury Inspector General for Tax Administration:
W&I: Wage and Investment:
United States Government Accountability Office:
Washington, DC 20548:
August 14, 2008:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
Created over 30 years ago, individual retirement accounts--popularly
known as IRAs--are a key tax-preferred vehicle for individuals to save
for retirement.[Footnote 1] According to the Internal Revenue Service's
(IRS) latest analysis, about 51 million taxpayers held $3.3 trillion in
IRAs at year-end 2004.[Footnote 2] IRAs also are increasingly important
as a way for individuals to roll over savings from pension plans. Total
assets in IRAs in 2007 surpassed assets held in either employer-
sponsored defined benefit or defined contribution plans.[Footnote 3]
According to estimates by the Department of the Treasury (Treasury),
IRAs cost the federal government an estimated $9.5 billion in forgone
revenue for fiscal year 2007.[Footnote 4] This reflects the revenue
losses by the federal government due to the preferential tax treatment
of both traditional and Roth IRAs.[Footnote 5] The traditional IRA
allows tax deferral on investment earnings until retirement
distribution with an up-front tax deduction from taxable income for
contributions by eligible taxpayers.[Footnote 6] To limit the tax
deferral, taxpayers over age 70½ cannot contribute to, and must begin
taxable distributions from, their traditional IRAs. In contrast, Roth
IRA contributions are not tax deductible and distributions are
generally not required for the account owner. Instead, subject to
income limitations, taxpayers regardless of age can make after-tax
contributions to Roth IRAs with retirement distributions, including
investment earnings, generally being tax-free. To limit revenue losses
and tax benefits from accruing disproportionately to the wealthy, the
law imposes a total annual limit on IRA contributions as well as income
limits on the deductibility of traditional IRA contributions and
eligibility for Roth IRAs. Contributions exceeding the limits are
subject to a 6 percent additional tax to penalize excess contributions.
Even with tax incentives for retirement saving, personal saving in the
United States remains near historic lows.[Footnote 7] To improve
personal saving, Congress has changed the IRA rules over the years, for
example, by increasing the contribution limits and allowing workers to
tap IRA assets for certain nonretirement purposes without the early
withdrawal penalty. In addition to the traditional tax-deferred IRA,
Congress in 1997 created the after-tax Roth IRA.[Footnote 8] There are
also two kinds of employer-based IRAs--Savings Incentive Match Plans
for Employees (SIMPLE) and Simplified Employee Pensions (SEP).[Footnote
9] Although providing taxpayers with more IRA options, these changes
also added complexity to the rules governing IRA contributions and
distributions. This complexity coupled with the various penalties on
IRA rule violations add to the compliance burden for taxpayers,
financial services firms acting as IRA custodians, and financial
planners and advisors, as well as the burden for IRS in enforcing the
IRA rules.
Some taxpayers--whether intentionally or unintentionally--fail to
comply with the rules. Some taxpayers may inadvertently contribute more
than allowed given their income limits. A taxpayer may have an
incentive to lie about the reason for an early withdrawal to avoid
penalty. Noncompliance with IRA rules--for example, overstated
deductions for contributions and underreported distributions from
traditional IRAs--can contribute to the gross tax gap, last estimated
at $345 billion for tax year 2001. The gross tax gap is the annual
difference between what taxpayers pay in taxes voluntarily and on time
and what they should pay under the law. Because of taxpayer
noncompliance, the burden of funding the nation's commitments falls
more heavily on taxpayers who willingly and accurately pay their taxes.
You asked us to examine taxpayer compliance and challenges with key IRA
rules. This report (1) provides an overview of key IRA contribution,
distribution, and other rules and describes how IRS educates taxpayers
on these rules; (2) describes what IRS knows about the extent of
noncompliance for IRA transactions reported on taxpayer returns; and
(3) describes the challenges taxpayers face with key IRA rules and some
options to strengthen taxpayer compliance. Separately, we issued to you
a Limited Official Use Only report detailing the results of our review
of IRS enforcement of taxpayer compliance with IRA rules.[Footnote 10]
This report, as negotiated with IRS, provides a public version of
material from our earlier report and supplements that report in that it
describes more fully the challenges facing taxpayers in navigating IRA
rules.
To provide an overview of key IRA rules, we relied primarily on IRS
Publication 590, which explains the rules that taxpayers are to follow
in contributing to, and receiving distributions from, an IRA. Specific
rules depend on account type. This report focuses on traditional and
Roth IRAs set up by individuals to save on their own.[Footnote 11] We
also spoke with IRS and Treasury officials and reviewed reports from
the Congressional Research Service, the Congressional Budget Office,
the Investment Company Institute, and others. To describe how IRS
educates taxpayers on these rules, we also interviewed IRS officials
conducting IRA service activities and reviewed other guidance, such as
the IRS Web site and various IRS publications.
To describe what IRS knows about the extent of taxpayer misreporting of
IRA transactions on their tax returns, we reviewed publications and
documents, interviewed IRS officials, and used the 2001 National
Research Program (NRP)--IRS's most recent research study of individual
taxpayer compliance--to estimate the extent of taxpayer misreporting.
Specifically, taxpayers report deductible contributions to and taxable
distributions from traditional IRAs on the Form 1040 individual income
tax return.[Footnote 12] We provide the margin of error based on 95
percent confidence for estimates from the NRP samples of individual tax
returns. We also used enforcement data supplied by two IRS compliance
programs, the Math Error program and the Automated Underreporter (AUR)
program. The Math Error program electronically checks for obvious math
errors as tax returns are processed, and the AUR program matches
taxpayer returns with IRA custodian-reported information.[Footnote 13]
We determined that the IRS research and enforcement data we used were
sufficiently reliable for the purposes of this report.
To describe the challenges taxpayers face with key IRA rules and some
options to strengthen taxpayer compliance, we reviewed documents from
IRS's enforcement and service programs that address IRAs. We also
interviewed IRS officials, as well as representatives knowledgeable
about IRAs from financial industry organizations and advisor
representatives, including the Securities Industry and Financial
Markets Association, American Bankers Association, and American
Institute of Certified Public Accountants. We conducted two rounds of
interviews with financial industry organizations and advisor
representatives. In the first round, we asked open-ended questions
about the challenges and options for strengthening compliance. In the
second round, we used a standard set of questions in the interviews
with the representatives to try to verify responses and obtain
additional context for the challenges and options mentioned. We limited
our discussion of the challenges and options identified to include only
those related to the key IRA rules reviewed in this report. These
challenges and options are not exhaustive nor are the trade-offs
associated with each option. (See app. I for further discussion of our
scope and methodology.) We conducted this performance audit from March
2008 through August 2008 in accordance with generally accepted
government auditing standards.[Footnote 14] Those standards require
that we plan and perform the audit to obtain sufficient, appropriate
evidence to provide a reasonable basis for our findings and conclusions
based on our audit objectives. We believe that the evidence obtained
provides a reasonable basis for our findings and conclusions based on
our audit objectives.
Results in Brief:
Taxpayers face a myriad of tax rules governing contributions to,
distributions from, and rollovers between accounts for traditional and
Roth IRAs. Taxpayers who fail to comply can face added taxes and
penalties, which may reduce their retirement savings. Both traditional
and Roth IRAs have rules governing eligibility to contribute, and all
IRA contributions are subject to an annual limit. For example,
eligibility to deduct (from taxable income) contributions to a
traditional IRA and to contribute to a Roth IRA depends on taxpayer
income and filing status, while coverage by an employer-sponsored
retirement plan only affects eligibility for deductible contributions
to a traditional IRA. Taxpayers who do not qualify for a traditional
IRA deduction can make nondeductible contributions, which come with
additional reporting rules. Tax rules for distributions diverge for
traditional and Roth IRAs. Whereas traditional IRA distributions are
fully taxable for a taxpayer who made only deductible contributions,
Roth IRA distributions are generally tax-free. For both IRA types,
distributions before age 59½ are generally subject to a 10 percent
early withdrawal penalty, with some exceptions, such as buying a first
home. Whereas Roth IRA owners are not required to take distributions
during their lifetime, taxpayers over age 70½ are required to take
minimum distributions from traditional IRAs or face a 50 percent
penalty on the required distribution amount. Rollovers, where a
taxpayer moves money from a pension plan or another IRA into an IRA,
must be completed within 60 days of the taxpayer receiving the money,
or the amounts are taxable and subject to penalty. To assist taxpayers
in voluntarily complying with IRA rules, IRS offers special
publications, notably Publication 590, and telephone assistance for
taxpayers with IRA questions.
Even with IRS's efforts to support taxpayers, IRS data show that some
taxpayers, whether intentionally or unintentionally, fail to comply
with rules for reporting contribution deductions and taxable
distributions from traditional IRAs. On the basis of the most recent
research results available, IRS estimated that in 2001, nearly 15
percent of those who made traditional IRA contribution deductions
misreported their deductions on their tax returns, and nearly 15
percent of taxpayers who took taxable distributions from traditional
IRAs misreported this information. IRS relies on automated enforcement
and examination programs to detect and correct these types of IRA
misreporting. The Math Error program, which checks for obvious errors,
found that thousands of taxpayers in 2006 tried to deduct contributions
over the limit for traditional IRAs. For tax year 2004 (the last full
year available), the AUR program, which matches tax returns with
information returns, assessed additional taxes of $23.2 million for
about 24,000 taxpayers for ineligible traditional IRA contribution
deductions or exceeding the deduction limits. The AUR program also
assessed $61.1 million in taxes and penalties for about 38,000
taxpayers taking early withdrawals from traditional IRAs.
As partly shown by taxpayer misreporting to IRS, taxpayers face
challenges in figuring how much they can contribute, navigating the
various distribution rules, and rolling over their IRAs between
custodians. Complexity of IRA rules was cited by IRS officials, IRA
custodians, and financial planners we interviewed as the overarching
contributor to challenges facing taxpayers in complying with IRA rules.
According to interviewees, taxpayers may not understand that the annual
contribution limit applies across traditional IRAs and Roth IRAs in
combination, and taxpayers with incomes in the phaseout ranges make
mistakes in calculating the partial amount for their eligible
contributions. On the distribution side, interviewees said that
taxpayers get confused over which exceptions for early withdrawals are
not subject to penalties, in part because the exceptions differ for
employer plans. Older taxpayers may make mistakes in determining when
they must start minimum distributions and calculating the correct
amounts, and the required minimum distribution rule poses a growing
challenge as the population ages and increasing amounts of pension
assets are rolled over into IRAs. Representatives of financial firms
and advisors we interviewed identified some options for IRS to clarify
IRA guidance, such as for the combined contribution limit rule, or
develop tools to help taxpayers comply, such as a Web-based calculator
for minimum distributions required for older taxpayers. IRS could
explore actions such as requiring additional reporting by custodians or
simplifying the required minimum distribution rule to help taxpayers to
comply with this complicated rule. Other options to reduce the
complexity of IRA contribution and distribution rules, such as
eliminating income limits, pose trade-offs and could be considered in
the context of broader tax reform.
To address the challenges facing taxpayers in complying with current
IRA rules, we recommend that IRS (1) clarify guidance to help taxpayers
better understand the combined contribution rule and (2) pursue
administrative options, including additional taxpayer guidance, and
work with Treasury on regulatory or legislative strategies to help
taxpayers comply with the required minimum distribution rule. In
comments on a draft of this report, IRS agreed to take actions
consistent with both of our recommendations. Treasury provided
technical comments, which we incorporated as appropriate.
Background:
According to IRS's Statistics of Income (SOI) research, of about 51
million taxpayers who owned IRAs as of 2004, nearly 41 million owned
traditional IRAs compared to more than 13 million taxpayers who owned
Roth IRAs, as shown in figure 1.[Footnote 15] Of the $3.3 trillion held
in IRAs as of 2004, traditional IRAs accounted for almost $3 trillion.
Traditional IRAs have grown not only from contributions but also from
rollovers from employer pension plans. First introduced in 1998, Roth
IRAs totaled $140 billion as of 2004. While Roth IRAs and employer-
based SIMPLE and SEP IRAs constitute a small share of IRA assets, the
number of taxpayers who own Roth IRAs surpasses the number of those
owning employer-based IRAs, as shown in figure 1. IRA assets surpass
assets held in either employer-sponsored defined benefit or defined
contribution plans.
Figure 1: Number of Taxpayers Owning IRAs and Fair Market Value of IRAs
by IRA Type, Tax Year 2004:
This figure is a combination of two bar graphs showing number of
taxpayers owning IRAs and fair market value of IRAs by IRA type, tax
year 2004. The left graph shows taxpayers owning IRAs, and the right
graph shows fair market value. The left graph has an X axis
representing number in millions, and the right graph has an X axis
representing dollars in millions.
Taxpayers owning IRAs;
Traditional IRAs: Number in millions: 40.8;
Roth IRAs: Number in millions: 13.5;
Employer IRAs[A]: Number in millions: 6.0.
Fair market value;
Traditional IRAs: Number in millions: 2,957;
Roth IRAs: Number in millions: 140;
Employer IRAs[A]: Number in millions: 203.
[See PDF for image]
Source: IRS.
[A] Employer IRAs include SEP and SIMPLE IRAs.
[End of figure]
According to IRS's SOI analysis, about 5.3 million taxpayers
contributed about $12.6 billion to traditional IRAs for tax year 2004,
and deductible contributions accounted for over three-quarters of that
amount. Also, about 6.7 million taxpayers contributed more than $14.7
billion to Roth IRAs for tax year 2004. Traditional IRA contributions
averaged $2,381 and Roth IRA contributions averaged $2,211 for tax year
2004. In addition to contributions, more than 3.6 million taxpayers
rolled over about $215 billion into traditional IRAs from employer
plans in 2004, according to IRS's SOI analysis.
Taxpayers contributing to Roth IRAs are younger on average than
traditional IRA owners, as illustrated in figure 2. On the basis of
IRS's SOI analysis for tax year 2004, more taxpayers under age 55
contributed to a Roth IRA than to a traditional IRA, while the reverse
is true for taxpayers ages 55 and over. Taxpayers over age 70 may
contribute to Roth IRAs, but contributions to traditional IRAs are not
allowed after age 70½.
Figure 2: Number of Taxpayers Contributing to Traditional and Roth IRAs
by Age, Tax Year 2004:
This figure is a vertical bar chart showing number of taxpayers
contributing to traditional and Roth IRAs by age, tax year 2004. The X
axis represents the taxpayer age, and the Y axis represents the number
of taxpayers (in thousands). One bar represents Traditional, and the
other represents Roth.
Age: Under 25;
Traditional: 72,678;
Roth: 328,718.
Age: 25 to under 35;
Traditional: 405,989;
Roth: 1,355,020.
Age: 35 to under 45;
Traditional: 1,003,217;
Roth: 1,781,585.
Age: 45 to under 55;
Traditional: 1,679,781;
Roth: 1,820,439.
Age: 55 to under 65;
Traditional: 1,721,671;
Roth: 1,146,825.
Age: 65 and over;
Traditional: 421,734;
Roth: 225,049.
[See PDF for image]
Source: IRS.
Notes: Data are from IRS's SOI. For the category 65 and over, data for
taxpayers contributing to traditional IRAs reflect taxpayers not over
age 70½. Data for taxpayers contributing to Roth IRAs reflect taxpayers
age 70 and over.
[End of figure]
Even with the sheer numbers of taxpayers owning IRAs, most taxpayers
eligible for IRAs do not take advantage of the opportunity to save for
retirement on a tax-preferred basis. According to IRS SOI estimates,
only 10 percent of those eligible contributed in 2004.[Footnote 16]
According to IRS's SOI analysis, about 12.3 million taxpayers withdrew
$140 billion--traditional IRA withdrawals accounted for more than 95
percent--during tax year 2004. Based on SOI estimates for tax year
2004, about 54 percent of taxpayers with IRA withdrawals were age 70
and older, withdrawing about $55 billion during 2004.
Myriad of Rules Govern IRA Transactions, and IRS Provides Services to
Educate Taxpayers:
Individuals face a myriad of tax rules in using tax-advantaged
traditional and Roth IRAs, and noncompliance can trigger taxes and
penalties that may reduce their retirement savings. As outlined in
table 1, rules governing IRAs and associated penalties generally can be
categorized into contribution rules, including contribution limits and
eligibility; distribution rules; and rollover rules.[Footnote 17]
Taxpayers and IRA custodians must also follow rules for reporting IRA
transactions. Publication 590 explains the IRA rules that taxpayers are
to follow, and IRS offers additional assistance through its Web site
and toll-free phone lines.
Table 1: General IRA Rules and Associated Penalties by Transaction
Type:
Transaction: Contribution rules for traditional IRA; Associated
rules[A]: * Deductible contribution limit for each tax year;
* Deductible contribution eligibility based on:
Having taxable compensation;
Age: did not reach age 70½ by end of year;
Whether taxpayer, or spouse, is an active participant in an employer-
sponsored retirement plan, and income limits depending on marital
filing status for those covered by such plans;
* Nondeductible contributions allowed regardless of income and pension
coverage;
* Contribution limit for each tax year[A,B];
* Excess contributions are subject to a 6 percent tax.
Transaction: Contribution rules for Roth IRA;
Associated rules[A]: * Contribution eligibility based on:
Having taxable compensation;
Income limits subject to marital filing status;
* Contribution limit for each tax year[A,B];
* Excess contributions are subject to a 6 percent tax.
Transaction: Distribution rules for traditional IRA;
Associated rules[A]: * Distribution is taxable income;
* Early distributions before age 59½ subject to 10 percent penalty
unless taken for specified reasons, such as disability or buying a
first home;
* Required minimum distributions starting at age 70½, subject to 50
percent penalty if not taken;
* Distribution rules for nondeductible IRAs are based on basis
calculations.
Transaction: Distribution rules for Roth IRA;
Associated rules[A]: * Distributions are not taxed if (1) account is at
least 5 years old and (2) owner is over age 59½, disabled, or a first-
time home buyer, or if distributions are paid to a beneficiary after
owner's death;
* Nonqualified distributions may be subject to tax to the extent that
distributions exceed after-tax contributions;
nonqualified distributions are subject to 10 percent penalty unless
taken for specified reasons, such as qualified higher education
expenses;
* No minimum distributions required during owner's lifetime, but
distributions generally required to be taken after IRA owner's death,
subject to 50 percent penalty if not taken.
Transaction: Rollover to traditional IRA rules;
Associated rules[A]: * Taxpayer has 60 days to roll over assets tax-
free from a retirement plan (pension or another traditional IRA) to a
traditional IRA, and only one rollover is allowed per year per
traditional IRA.
Transaction: Conversion from traditional IRA to Roth IRA rules[C];
Associated rules[A]: * No limit on amount that can be converted;
* Conversion eligibility subject to income limit and filing status;
* Generally, conversion amounts are taxable income when converted.
Source: GAO analysis of IRS Publication 590.
[A] This is a simplified representation of rules for traditional and
Roth IRAs; eligibility and contributions limits, among other rules,
have varied from year to year as discussed further below.
[B] In addition to the contribution limit for traditional IRAs, there
is a combined annual limit for traditional and Roth IRAs.
[C] Beginning in 2008, amounts from any retirement plan can be
converted to a Roth IRA. Beginning in 2010, income limits on
conversions are eliminated.
[End of table]
Contribution Rules:
Both traditional and Roth IRAs have rules governing eligibility to
contribute, and all IRA contributions are subject to an annual limit.
For both IRA types, eligibility is limited to taxpayers with taxable
compensation.[Footnote 18] For a traditional IRA in tax year 2008,
eligibility for a full or partial deduction from taxable income depends
on whether a taxpayer or spouse is covered by an employer-sponsored
retirement plan as well as limits on modified adjusted gross income
(AGI)[Footnote 19] and filing status, as shown in table 2. For example,
a single taxpayer not covered by an employer plan can take a full
deduction regardless of income, and a married taxpayer filing jointly
whose spouse is covered by an employer plan can take the full deduction
if the couple's modified AGI was $159,000 or less for 2008. A taxpayer
ineligible for any deduction based on pension coverage or modified AGI
can still make nondeductible contributions to a traditional IRA. A
taxpayer in the phaseout range who is married and filing jointly or a
qualified widower has to figure out the deductible contribution portion
and decide whether to contribute the rest on a nondeductible
basis.[Footnote 20]
Table 2: Eligibility for Deduction of Traditional IRA Contributions,
Tax Year 2008:
[See PDF for image]
Source: IRS.
Note: Data are from IRS Publication 590. Publication 590 includes
details on calculating deductions for taxpayers taking partial
deductions.
[End of table]
For a Roth IRA, eligibility also depends on modified AGI and filing
status, as shown in table 3. For example, a single taxpayer with
modified AGI of less than $101,000 is eligible for a full contribution
in 2008, and married taxpayers filing jointly with modified AGI of less
than $159,000 also are eligible for a full contribution. A single
taxpayer with AGI of at least $116,000 or married taxpayers filing
jointly with AGI of $169,000 or more cannot contribute to a Roth IRA
for 2008. Taxpayers in the income phaseout range have reduced
contribution limits. Coverage by an employer-sponsored retirement plan
does not affect eligibility for a Roth IRA.
Table 3: Eligibility for Roth IRA Contributions, Tax Year 2008:
[See PDF for image]
Source: IRS.
Note: Data are from IRS Publication 590.
[End of table]
Both traditional and Roth IRAs are subject to annual contribution
limits. Table 4 shows how the annual limit has changed over time and
varies depending on a taxpayer's age. For 2008, taxpayers under age 50
can contribute up to $5,000 and those over the age of 50 and under age
70½ can contribute up to $6,000 to traditional and Roth IRAs. Taxpayers
age 70½ and older can contribute to a Roth IRA only. Contributions can
be made any time during a year or by the due date for filing a tax
return, not including extensions. For example, contributions for 2008
must be made by April 15, 2009. A taxpayer who contributes less than
the annual limit cannot make up the difference after that date.
Table 4: Maximum IRA Contribution Limits for IRA Owners by Age, Tax
Years 1975-2008:
Tax years: 1975-1981;
Age 49 and below: $1,500;
Age 50 and over[A]: $1,500.
Tax years: 1982-2001;
Age 49 and below: 2,000;
Age 50 and over[A]: 2,000.
Tax years: 2002-2004;
Age 49 and below: 3,000;
Age 50 and over[A]: 3,500.
Tax years: 2005;
Age 49 and below: 4,000;
Age 50 and over[A]: 4,500.
Tax years: 2006-2007;
Age 49 and below: 4,000;
Age 50 and over[A]: 5,000.
Tax years: 2008[A];
Age 49 and below: 5,000[B];
Age 50 and over[A]: 6,000[B].
Source: Congressional Budget Office.
[A] Catch-up contributions for taxpayers age 50 and older were
effective beginning in 2002. Taxpayers age 70½ and older can contribute
to Roth IRAs only.
[B] After 2008, increases in contribution limit (excluding additional
contributions allowed for ages 50 and over) will be indexed for
inflation in $500 increments.
[End of table]
Total contributions to Roth and traditional IRAs in any year cannot
exceed the combined contribution limit. Any contribution in excess of
the limit or made by an ineligible taxpayer is subject to a 6 percent
penalty annually if the excess amount--and any earnings--is not
withdrawn by the date the return for the year is due, including
extensions. A taxpayer can choose to either withdraw an excess
contribution to avoid the penalty or carry the excess forward as a
contribution for a later year but still is liable for the excess
contribution penalty. For example, if a taxpayer contributes more than
allowed in 2008, that taxpayer has until April 15, 2009, to remove the
excess, or the taxpayer can pay the penalty for 2008 and apply the
excess as contributions for 2009.[Footnote 21] A taxpayer also can
treat a contribution made to one IRA as having been made to a different
IRA type; this is known as a recharacterization. For example, a
taxpayer ineligible for a Roth IRA could recharacterize a contribution
and transfer the amount to a traditional IRA.
Distribution Rules:
Whereas both IRA types share a combined contribution limit and have
rules limiting eligibility, tax rules for distributions diverge for
traditional and Roth IRAs. Traditional IRA distributions are taxable in
the year received. Distributions are fully taxable for a taxpayer who
made only deductible contributions and partially taxable for a taxpayer
who also made nondeductible contributions.[Footnote 22] In contrast,
Roth IRA distributions are tax-free after age 59½ as long as the
taxpayer has held the Roth IRA for 5 years.[Footnote 23] For both
traditional and Roth IRAs, early distributions before age 59½ for
reasons other than specific exceptions result in 10 percent additional
tax.[Footnote 24]
Another key difference between traditional and Roth IRAs is the
required minimum distribution rule to limit tax benefit from earnings
accumulating on a tax-preferred basis in an IRA. Taxpayers age 70½ are
required to take minimum distributions from tax-deferred traditional
IRAs, whereas Roth IRA owners are not required to take distributions
during their lifetime. Under 2002 regulations, which simplified the
calculation, required minimum distributions for a traditional IRA are
calculated using the previous year's fair market value divided by life
expectancy based on a uniform table.[Footnote 25] A taxpayer must begin
required minimum distributions by April 1 of the year after turning age
70½. The second distribution must be made by December 31 of the year
containing this April 1, and subsequent required minimum distributions
must be made by December 31. Failure to take the required minimum is
subject to a 50 percent penalty on the required amount not distributed.
A taxpayer may request that IRS excuse the penalty if the excess
accumulation is due to reasonable error and the taxpayer is taking
steps to draw down the excess. Beneficiaries inheriting either IRA type
are required to take minimum distributions, and the rules depend on
whether the beneficiary is a surviving spouse, other individual, or an
entity, such as a trust.
Rollover and Conversion Rules:
Rollovers, where a taxpayer moves money from a pension plan or an IRA
into another IRA, are also subject to rules specifying that a tax-free
rollover must be completed within 60 days of the taxpayer receiving the
money and that only one IRA-to-IRA rollover is allowed per traditional
IRA during a 1-year period. If a taxpayer does not roll over money
within the allowed time or rolls over an IRA too frequently, the
transaction does not qualify for tax-free treatment. For a failed
rollover, the distribution from the first IRA is taxable and subject to
the 10 percent early distribution penalty if the taxpayer is younger
than age 59½. Further, amounts contributed in excess of the annual
limit to the second IRA are subject to a 6 percent additional tax to
penalize excess contributions. IRS has authority to waive the 60-day
requirement and extend the rollover period where the failure to do so
would be against good conscience, such as in the event of a disaster or
an event beyond the taxpayer's reasonable control. The 60-day
requirement is automatically waived in the cases of financial
institution errors in transferring and depositing the rollover funds.
Otherwise, a taxpayer can pay a user fee and apply for a private letter
ruling requesting a waiver.[Footnote 26] A direct transfer between IRA
trustees is not considered a rollover and is not subject to the 1-year
waiting period. Similarly, a recharacterization of contributions from
one type of IRA to another IRA type is not considered a rollover
subject to the 1-year waiting period.
Conversions, where a taxpayer pays taxes deferred in a traditional IRA
to convert those amounts to a Roth IRA, are subject to income
eligibility rules.[Footnote 27] For tax year 2007, a taxpayer with
modified AGI of $100,000 or less and not married filing separately is
eligible to make a Roth conversion.[Footnote 28] If a taxpayer is
ineligible and the conversion fails, unless recharacterized, amounts
distributed from the traditional IRA before age 59½ are subject to a 10
percent penalty, and the Roth IRA contribution in excess of the annual
limit is subject to a 6 percent additional tax.
IRS Reporting Rules for Taxpayers and IRA Custodians:
Taxpayer reporting rules differ for traditional IRAs and Roth IRAs. For
a traditional IRA, a taxpayer reports deductible contributions on line
32 of the individual tax return (Form 1040), and the deduction reduces
a taxpayer's current taxable income. A taxpayer is to report taxable
traditional IRA distributions--including amounts converted to a Roth
IRA--as income on line 15 of the individual tax return.[Footnote 29]
Any taxpayer who makes a nondeductible traditional IRA contribution or
receives a distribution from a traditional IRA and ever made
nondeductible traditional IRA contributions must also file Form
8606.[Footnote 30] In contrast to nondeductible traditional IRA
contributions, taxpayers do not report Roth IRA contributions to IRS,
and Roth IRA distributions are tax-free and generally are not reported
on the 1040 tax return.[Footnote 31] Taxpayers who contributed more
than allowed to a traditional or Roth IRA, withdrew money before age
59½, or failed to take required minimum distributions must file Form
5329 to report the associated penalties due.
Custodians, including banks or mutual funds holding account owners' IRA
assets, follow the same basic procedures for traditional and Roth IRA
contributions and distributions in terms of reporting to IRS. For both
traditional and Roth IRAs, the custodian is required to submit a Form
5498 detailing the total contributions, rollovers, recharacterizations,
and fair market value for every IRA. For example, for a taxpayer
holding one traditional IRA and two Roth IRAs, the custodian should
send three Form 5498s to the taxpayer and IRS. Given that taxpayers
have until the return filing date to contribute to an IRA, the due date
for filing Form 5498 is May 31. Custodians are also to report on Form
5498 whether a taxpayer is subject to required minimum distributions
for the coming year but are not required to report to IRS the minimum
amount calculated for each account. Instead, the custodians must report
the minimum required distribution amount to the taxpayer or at least
offer to calculate the amount; the statement or offer must include the
date by which the amount must be distributed. For both traditional and
Roth IRAs, the custodian is also required to submit a Form 1099-R each
year that a withdrawal takes place detailing the total distributions
taken from the account during the calendar year and providing some
information about the distribution, such as whether the distributions
were taken before age 59½ and whether a known penalty exception
applies. The due date for filing Form 1099-R with IRS is February 28.
Another key information report is the Form W-2 from employers showing
compensation and employer pension plan coverage used in determining
eligibility for traditional IRA deductions.
Third-party reporting by IRA custodians provides information that
taxpayers can use in preparing their tax returns and that IRS can use
to identify noncompliant taxpayers. Figure 3 illustrates what taxpayers
report for a traditional IRA contribution deduction and what custodians
report on Form 5498 about the contribution. Mismatches between these
two sources of information can trigger an enforcement response by IRS.
Likewise, mismatches between distributions reported by custodians on a
1099-R and taxpayers' individual tax returns can trigger enforcement by
IRS.
Figure 3: Illustrative Example of Using Form 1040 with Information
Reporting to Check Taxpayer Compliance with Traditional IRA Rules:
This figure is a picture of an illustrative example of using form 1040
with information reporting to check taxpayer compliance with
traditional IRA rules.
[See PDF for image]
Source: IRS.
[End of figure]
IRS's Service Activities Aim to Increase Taxpayer Understanding of IRA
Rules:
IRS service activities aim to increase taxpayer understanding of and
improve taxpayer compliance with IRA rules for traditional and Roth
IRAs. IRS's Media and Publications office offers publications, forms,
and forms instructions to help taxpayers complete their tax returns
accurately. IRS updated the 2006 Publication 590 to reflect new
legislation, permanently raising the IRA contribution limits and
indexing them for inflation. IRS also developed procedures and guidance
for the new provision effective for tax year 2006, allowing those ages
70½ and older to exclude from gross income an amount that does not
exceed $100,000 if it is distributed for charitable purposes directly
from their traditional IRAs. For 2007, IRS updated Publication 590 to
reflect new provisions for onetime IRA transfers to fund a qualified
health savings account and catch-up contributions for pension plan
participants whose employers went bankrupt. Financial industry
organizations and advisor representatives we interviewed complimented
Publication 590 for translating the myriad of complicated IRA
contribution and distributions rules into "plain English" to help
taxpayers comply.
IRS also provides special publications that include IRA information for
taxpayers seeking assistance at IRS walk-in centers or for those
consulting the IRS Web site. Further, taxpayers seeking assistance with
IRA questions can call the IRS toll-free lines. IRS employees are
trained with a probe and response guide to accurately answer questions
about IRA rules.
IRS Research and Enforcement Data Show Taxpayers Misreport Millions of
Dollars in Traditional IRA Transactions:
IRS research and enforcement data show that some taxpayers misreported
in aggregate millions of dollars in traditional IRA contributions and
distributions on their tax returns.[Footnote 32] The NRP examination
study of tax year 2001 returns, the most recent research results
available, showed that nearly 15 percent of those who made traditional
IRA contribution deductions misreported their deductions on their tax
returns, and nearly 15 percent of taxpayers who took taxable
distributions from traditional IRAs misreported this information. IRS
relies primarily on automated enforcement to detect misreported IRA
contribution deductions and taxable distributions. IRS first checks tax
returns for obvious IRA contribution errors and then matches tax
returns to custodian-reported information to ensure, among other
things, that taxpayers reported taxable distributions. For example, the
AUR program, in tax year 2004, assessed taxes and penalties totaling
about $61 million from almost 38,000 taxpayers who misreported early
distributions from traditional IRAs.
Research Shows Taxpayers Misreport Millions in Traditional IRA
Transactions:
The NRP study of tax year 2001 returns, the most recent research
results available, reported numbers of taxpayers who either misreported
deductions for their traditional IRA contributions or misreported taxes
when taking withdrawals. NRP results for 2001 yield a measure of
noncompliance across taxpayers.[Footnote 33]
* Of taxpayers who made deductible traditional IRA contributions, an
estimated 14.8 percent[Footnote 34] (554,657 taxpayers)[Footnote 35]
did not accurately report the IRA deduction on their individual tax
returns--10.4 percent overstated their deductible contributions (that
is, exceeded the applicable limit) and 4.4 percent underreported their
deductible contributions (that is, reported less on their returns than
they actually could deduct).[Footnote 36] The understated net income
due to these misreported traditional IRA contribution deductions was
$392 million,[Footnote 37] including both taxpayers who either
overstated or understated their contribution deductions to a
traditional IRA. For example, a taxpayer is considered to have
overstated a deduction if the deduction reported exceeds the taxpayer's
actual contribution or if the deduction is higher than the taxpayer's
eligibility allows.
* Of taxpayers who had taxable traditional IRA distributions, an
estimated 14.6 percent[Footnote 38] (1.5 million taxpayers)[Footnote
39] misreported withdrawals from their traditional IRA distributions--
13.7 percent understated (that is, reported an amount less than what
the taxpayer withdrew) and 0.9 percent overstated IRA distributions
(that is, reported an amount greater than what the taxpayer
withdrew).[Footnote 40] The underreported net income due to misreported
IRA distributions was $6.3 billion,[Footnote 41] including taxpayers
who failed to report early distributions and the associated tax.
The 2001 NRP data did not provide a measure of noncompliance for some
IRA transactions not reported directly on the Form 1040 tax return. For
example, because Roth IRA contributions are not reported, the 2001 NRP
study did not capture information on taxpayer errors under Roth IRA
contribution rules. While NRP does cover misreporting of distributions
taken, the 2001 NRP study did not capture estimates of noncompliance
for older taxpayers who failed to take required minimum distributions
from their traditional IRAs. IRS officials told us that for the
upcoming NRP for tax year 2007, they are planning to gather additional
information about taxpayer as well as custodian misreporting of IRA
transactions.
Automated Enforcement Detects and Corrects Millions in IRA
Noncompliance:
Whereas NRP yields a measure of taxpayer misreporting of traditional
IRA transactions, IRS enforcement data reflect cases where IRS pursued
taxpayers who appeared to not comply in reporting their IRA deductions
or traditional IRA distributions on their tax returns.[Footnote 42]
Through automated checks and document matching, IRS detects and
corrects millions of dollars in taxpayer misreporting of IRA
transactions. The Math Error program checks for obvious math errors as
returns are processed, and the AUR program matches returns with
custodian-reported information. Larger early withdrawal matching cases,
including failed rollovers, are subject to correspondence examination.
Figure 4 provides an overview of IRS's automated enforcement activities
for IRA transactions reported on tax returns.
Figure 4: Overview of IRS Automated Enforcement Activities for IRA
Rules:
This figure is a flowchart showing the overview of IRS automated
enforcement activities for IRA rules.
[See PDF for image]
Source: GAO analysis of IRS information.
[End of figure]
Math Error Program:
As tax returns are processed, the Math Error program reviews
traditional IRA deductions claimed by taxpayers for amounts higher than
allowable limits. For example, the Math Error program tests whether a
taxpayer claimed a deduction greater than the maximum annual
contribution limit. The Math Error program adjusts every taxpayer
return for which an error is found to reflect any change in the
deduction and sends a math error notice to the taxpayer.[Footnote 43]
From tax years 2003 through 2006, IRS issued thousands of math error
notices annually to taxpayers misreporting deductions on their
traditional IRAs. IRS continues to use the Math Error program because
IRA math errors must be resolved to process tax returns and adjust the
tax liability so that taxpayers are in compliance.
In May 2007, IRS officials told us that the Math Error program would
discontinue age-based tests for traditional IRA contribution deductions
because IRS does not have authority to use the Math Error program for
IRA age rules.[Footnote 44] Starting in 2003, IRS used Social Security
Administration age data during initial return processing to test
taxpayers claiming traditional IRA contribution deductions. This up-
front check allowed IRS to implement the higher contribution limit for
taxpayers age 50 and over and also to check the lower limit allowed for
taxpayers below age 50. For example, for tax year 2004, a taxpayer
below age 50 could contribute up to $3,000 and a taxpayer age 50 or
over could contribute up to $3,500. For 2007, the Math Error program
will test that no taxpayer exceeds the highest limit allowed.
Automated Underreporter Program:
Whereas the Math Error program checks for conspicuous errors in the
taxpayer's return, the AUR program compares information reported on the
individual tax return with third-party information reported by
financial institutions for individual taxpayers. The AUR program
creates an inventory of potential cases by matching taxpayer return
data with the information return file to verify that all income and
deductions are reported accurately. An underreporter case results when
computer analysis detects a discrepancy between the tax return and the
information returns. Because of resource constraints, IRS officials
said that they do not contact taxpayers in all cases where the AUR
program finds a mismatch between what was reported on an information
return and what was reported on a tax return. If a mismatch occurs over
a certain tax threshold, IRS decides if the mismatch warrants a notice,
asking the taxpayer to explain the discrepancies, such as when a
taxpayer inadvertently fills in the wrong line on the tax return, or
pay any taxes assessed. AUR reviewers are directed to consider the
reasonableness of the taxpayers' responses to notices but generally do
not examine the accuracy of the information in the responses because
they do not have examination authority.
For tax year 2001, AUR contacts represented about 2 percent of the
noncompliant taxpayers estimated by NRP of either taking an ineligible
deduction or overdeducting contributions for traditional IRAs, with
about 9,000 taxpayers assessed by the AUR program compared with nearly
555,000 taxpayers estimated by NRP.[Footnote 45] For tax year 2004, the
last full year for which data are available, of 25,000 mismatches for
taxpayers potentially ineligible for the contribution deduction, IRS
assessed additional taxes of $7 million for nearly 9,000 taxpayers. Of
about 85,000 mismatches for taxpayers who potentially overdeducted
their traditional IRA contributions, the AUR program assessed
additional taxes of $16.2 million for about 15,000 taxpayers for tax
year 2004. Table 5 shows the numbers of taxpayers and total additional
taxes assessed for misreported traditional IRA deductions for tax years
2001 to 2004. The AUR program does not necessarily work these IRA cases
on a stand-alone basis and may pursue potential IRA deduction
misreporting along with other discrepancies for taxpayers in the AUR
inventory.
Table 5: Total Additional Taxes and Taxpayers Assessed by IRS's
Automated Underreporter Program on Select Contribution and Distribution
Rules for Traditional IRAs, Tax Years 2001-2004:
Dollars in millions.
Tax year: 2001;
Ineligible for deduction: Amount: $4.4;
Ineligible for deduction: Taxpayers assessed: 5,792;
Overdeduction of contribution: Amount: $3.8;
Overdeduction of contribution: Taxpayers assessed: 3,218;
Early distribution penalty: Amount: $20.3;
Early distribution penalty: Taxpayers assessed: 5,517.
Tax year: 2002;
Ineligible for deduction: Amount: 5.9;
Ineligible for deduction: Taxpayers assessed: 5,810;
Overdeduction of contribution: Amount: 10.9;
Overdeduction of contribution: Taxpayers assessed: 10,175;
Early distribution penalty: Amount: 79.4;
Early distribution penalty: Taxpayers assessed: 41,962.
Tax year: 2003;
Ineligible for deduction: Amount: 8.8;
Ineligible for deduction: Taxpayers assessed: 12,269;
Overdeduction of contribution: Amount: 14.6;
Overdeduction of contribution: Taxpayers assessed: 14,128;
Early distribution penalty: Amount: 71.1;
Early distribution penalty: Taxpayers assessed: 45,582.
Tax year: 2004;
Ineligible for deduction: Amount: 7.0;
Ineligible for deduction: Taxpayers assessed: 8,687;
Overdeduction of contribution: Amount: 16.2;
Overdeduction of contribution: Taxpayers assessed: 15,088;
Early distribution penalty: Amount: 61.1;
Early distribution penalty: Taxpayers assessed: 37,900.
Source: IRS.
Notes: Data are from the AUR program. Tax year 2005 data are not
complete. The AUR program also enforces taxable distributions from
traditional IRAs, but those data are included with distributions from
other qualified retirement plans. Larger-value early distribution cases
for tax years 2001 and beyond were worked by Correspondence
Examinations. Tax assessments for each category are independent from
each other and are not double counted.
[End of table]
We could not isolate the AUR data on additional taxes assessed on
taxpayers who misreported distributions from traditional IRAs because
those data are combined with misreporting of taxable distributions from
other retirement plans. The AUR program does, however, capture separate
data for taxpayers who misreported early distributions from their
traditional IRAs. In tax year 2004, of about 420,000 mismatches, the
AUR program assessed taxes against about 38,000 taxpayers. As shown in
table 5, the AUR program assessed total taxes and penalties of $61.0
million on taxpayers who misreported early distributions from
traditional IRAs in that year.[Footnote 46] In addition to those cases
with assessments, the AUR program follows up with taxpayers on some
cases where the Form 1099-Rs filed by custodians reported that no known
penalty exception applies for an early distribution. According to a
financial industry organization representative we interviewed,
custodians play a limited role in reporting whether an exception
applies because a custodian may not know why a taxpayer took a
distribution and is not in a position to validate exceptions reported
by the taxpayer.
IRS is considering a new compliance initiative that could alert more
taxpayers about their misreported IRA transactions. According to IRS
compliance officials, when fully implemented a new AUR "soft notice"
program would send letters to many taxpayers in the AUR inventory
asking them to voluntarily fix their noncompliance by filing amended
returns, or to not repeat the action the following year. A soft notice
requires a taxpayer to take minimal actions and is intended to educate
and stimulate compliance without IRS having to invest substantial
resources. With phased rollout proposed to begin in fiscal year 2009,
many taxpayers detected by the AUR program as misreporting traditional
IRA deductions or distributions could ultimately receive soft notices
under this proposal.
Correspondence Examinations:
For taxpayers who withdraw large amounts from their traditional IRAs
before retirement age, a division under Correspondence Examinations
handles larger AUR matching cases involving the additional 10 percent
penalty and taxes due on early distributions. Through Correspondence
Examinations, IRS can determine if taxpayers qualified for a penalty
exception using some automated filters. For example, IRS employees can
filter out early distribution exceptions for disability using
information reported on Form 1099-R or the issuance of Form 1099-SSA.
Correspondence Examinations may also ask the taxpayer for further
documentation of an exception claimed. In fiscal year 2004, 20,771
taxpayers agreed with the proposed assessments for an average tax
change of $1,313.
One aspect of IRA noncompliance detected through the early distribution
rule check by Correspondence Examinations is failed rollovers.
Taxpayers have the option to withdraw funds from one traditional IRA
and roll them over to another traditional IRA. If the taxpayer fails to
complete a rollover at all and is under age 59½, Correspondence
Examinations will treat the withdrawn funds as an early distribution
and the taxpayer is subject to the 10 percent penalty. An examiner may
detect a late rollover in a case where a taxpayer provides additional
documentation showing the dates of the distribution and the subsequent
deposit.
Field Examinations:
Beyond systematic checks through its automated programs, IRS can also
address IRA noncompliance through its field examination program.
According to IRS examination officials, issues related to IRA
transactions may surface when an examiner is working an examination
case. For example, an examiner could uncover underreported income from
an IRA distribution during a probe of a taxpayer's reported income or
determine that a taxpayer failed to complete a rollover within the 60-
day limit. According to examination officials, an examiner may also
revisit traditional IRA eligibility if an examination results in other
adjustments to the taxpayer's income.
Complexity Underlies the Challenges That Taxpayers Face in Complying
with IRA Rules, and Some Options Could Bolster IRS Service While Other
Options Would Require Legislative Change:
In using traditional and Roth IRAs to save for their own retirement,
taxpayers face challenges in figuring how much they can contribute,
navigating the various distribution rules, and moving their IRAs
between custodians. Complexity of IRA rules was cited as the
overarching contributor to challenges facing taxpayers and IRS in
ensuring compliance with IRA rules by IRS officials, IRA custodians,
and financial planners we interviewed. Table 6 highlights some
challenges that taxpayers face with specific IRA rules. Representatives
of financial firms and advisors we interviewed identified some options
for IRS to clarify IRA guidance or offer additional IRA service
activities.[Footnote 47] Some options to reduce IRA rule complexity
would require changing the laws governing IRA contributions and
distributions.
Table 6: Taxpayer Challenges in Complying with Key IRA Rules:
Key IRA rules: Contributions: Annual contribution limit;
Challenges for taxpayers: Some taxpayers may not understand that the
annual contribution limit applies across both traditional and Roth
IRAs.
Key IRA rules: Contributions: Income eligibility for traditional IRA
deduction and Roth IRA contribution;
Challenges for taxpayers: Some taxpayers' year- end modified AGI
exceeds the income eligibility limit after they already made their
contributions; Some taxpayers with modified AGI in phaseout ranges near
the income limits make mistakes in calculating the partial amount for
their eligible traditional IRA deduction or Roth IRA contribution.
Key IRA rules: Contributions: Pension participation rules for
traditional IRA contribution deduction;
Challenges for taxpayers: Some taxpayers participating in employer
pension plans make mistakes in calculating the deductible portion of
any traditional IRA contributions; Some taxpayers are unaware that
their employers made contributions to their employer-sponsored
retirement plans until they receive their W-2s in January, after having
already made their IRA contributions.
Key IRA rules: Contributions: Recordkeeping for nondeductible
traditional IRA contributions;
Challenges for taxpayers: Some taxpayers fail to track the taxable
basis for nondeductible contributions over time, and some could end up
paying taxes on their full distributions rather than the taxable
portion.
Key IRA rules: Distributions: Taxable withdrawals from traditional
IRAs;
Challenges for taxpayers: Some taxpayers fail to report traditional IRA
distributions, which are generally taxable, on their tax returns.
Key IRA rules: Distributions: Early withdrawals subject to penalty;
Challenges for taxpayers: Some taxpayers may get confused over which
exceptions for early withdrawals are not subject to penalty, in part
because the exceptions differ for IRAs and employer plans; Some
taxpayers may make mistakes in figuring out the taxes due on early
distributions from Roth IRAs during the 5-year holding period.
Key IRA rules: Distributions: Required minimum distribution from
traditional IRAs; Challenges for taxpayers: Some taxpayers make
mistakes in determining when they must start minimum distributions and
calculating the correct amount.
Key IRA rules: Rollovers: Sixty-day rule for tax-free rollover between
IRAs; Challenges for taxpayers: Direct transfers between custodians are
not available in all cases, and taxpayers make mistakes in completing
indirect rollovers within 60 days.
Source: GAO analysis.
Notes: The list of challenges in this table does not represent all
challenges mentioned to us during our audit. These challenges were
identified through a three-part process. First, we spoke to
representatives of financial firms and advisors to identify the range
of challenges. We then analyzed the information gathered to identify
challenges commonly raised by the interviewees. Using that list, we
conducted second round interviews with the same representatives for
reactions about the overall list. We analyzed the second round list,
and with our knowledge of rules and IRS interviews, we identified key
challenges. We also vetted the list with IRS and Treasury.
[End of table]
Challenges with IRA Contribution Rules:
Even as IRS works to inform taxpayers about IRA contribution rules,
some taxpayers remain confused about whether and how much they can
contribute, according to financial industry organization and advisor
representatives we interviewed. Some contribution rule challenges span
both traditional and Roth IRAs, while other challenges related to
whether a traditional IRA contribution is deductible and how to keep
records for nondeductible contributions.
Some taxpayers may not understand the annual limits on IRA
contributions in part because the limits have changed over recent years
and vary by taxpayer age. For example, the 2007 limit for both kinds of
IRAs was $4,000 for taxpayers under age 50 and $5,000 for taxpayers age
50 and older, and the 2008 limits are $5,000 and $6,000, respectively.
As IRS's math error data show for tax years 2003 to 2006, some
taxpayers try to deduct more than their legal limit for traditional IRA
contributions. According to the Treasury Inspector General for Tax
Administration (TIGTA), taxpayers over age 70½ continue to improperly
claim traditional IRA deductions.[Footnote 48] Financial industry
organization and advisor representatives we interviewed agreed that the
annual contribution limit rule, with the amount indexed for inflation
beginning in 2009, could confuse some taxpayers, but they did not see
complying with the contribution limit as a major challenge. According
to interviewees, IRS publishes the limits well ahead of when they
become effective, and IRA custodians and financial advisors reach out
to advise taxpayers on any changes. While custodians typically would
not accept a contribution exceeding the annual limit, a custodian would
not know if a taxpayer contributed to other IRAs for the same tax year.
According to some interviewees, taxpayers may be confused by the
combined limits and some may not understand that the total limit
applies across traditional and Roth IRAs and is not a limit for each
type. Currently, the 2007 IRS Publication 590 discusses the total
contribution limit in the traditional IRA chapter on page 11: "If you
have more than one IRA, the limit applies to the total contributions
made on your behalf to all your traditional IRAs for the year." Page 11
also has a caution: "Contributions on your behalf to a traditional IRA
reduce your limit for contributions to a Roth IRA. See chapter 2 for
information about Roth IRAs." On page 60 in the Roth IRA chapter,
traditional IRA and Roth IRA contribution limits are discussed, as
follows: "If contributions are made to both Roth IRAs and traditional
IRAs established for your benefit, your contribution limit for Roth
IRAs generally is the same as your limit would be if contributions were
made only to Roth IRAs, but then reduced by all contributions for the
year to all IRAs other than Roth IRAs. Employer contributions under a
SEP or SIMPLE IRA plan do not affect this limit." Even though the
publication explains the rule separately in each chapter, we believe
the various statements could be confusing to some taxpayers,
particularly those who may not read both chapters. According to IRS
officials we interviewed, other options to help clarify the guidance
about the rule could include repeating the total contribution limit in
the general reminder section up front in Publication 590 as well as on
the IRS Web site and in other IRS outreach materials. For example, IRS
included a reminder about the total contribution limit in its summer
2008 employer plans newsletter for tax practitioners, and IRS could
include a similar reminder in the annual press release announcing the
new contribution limits for the upcoming year.
Income eligibility rules are a challenge for both traditional and Roth
IRAs. Taxpayers over certain income limits cannot contribute to a Roth
IRA and cannot deduct traditional IRA contributions.[Footnote 49]
Interviewees also said that one reason taxpayers may be ineligibly
contributing is because their year-end modified AGI exceeds the
eligibility limit after they have already made the contribution. In
addition, taxpayers must determine their partial deduction amounts if
their modified AGI falls within certain phaseout ranges near the income
limit for eligibility. The phaseouts, thus, introduce opportunities for
some taxpayers to err by overdeducting their traditional IRA
contributions or overcontributing to a Roth IRA. IRA contributions
errors can contribute to the gross tax gap. For example, for tax year
2004, IRS's AUR program assessed $23.2 million in additional tax on
nearly 24,000 taxpayers who overdeducted or ineligibly deducted
traditional IRA contributions.
Interviewees generally agreed that the pension participation rule is a
major challenge for taxpayers trying to determine their eligibility for
a traditional IRA contribution deduction. Taxpayers who are single,
heads of households, or qualifying widows/widowers and married couples
not covered by any employer retirement plan are eligible for the full
deduction regardless of income. Interviewees said that taxpayers might
be ineligibly contributing because they are unaware that their
employers made contributions to their employer-sponsored retirement
plans until they receive their W-2s in January, after having already
made their IRA contributions. According to some interviewees, some
taxpayers may not understand the definition of "active
participant."[Footnote 50] One representative suggested that the
definition for active participant in an employer-sponsored plan could
be clarified to reduce confusion among employers and taxpayers and to
ensure that employers mark the W-2 correctly. However, an IRS official
knowledgeable about employer plans said that the W-2 guidance details
how employers are to handle the W-2 checkbox. In turn, individuals need
to know their participation status but not the full rule. According to
the official, individuals receive a breadth of benefit information when
hired, and they simply may not remember that they are enrolled in their
new employer's retirement plan until they receive their W-2s.
When a taxpayer contributes to a Roth IRA when he or she is ineligible
because of filing status or the modified AGI limits, one way to correct
the ineligible contribution and avoid the 6 percent penalty is to
recharacterize. However, the recharacterization process--treating a
contribution made to an IRA as having been made to a different IRA type
and transferring the amount between IRAs--can be confusing for
taxpayers, according to representatives we interviewed.[Footnote 51] To
avoid possible errors and the burden of recharacterization, taxpayers
could, for example, wait until they receive their 2008 W-2s to check
their 2008 income eligibility and retirement plan coverage and then
make their eligible 2008 IRA contributions by April 15, 2009. However,
some taxpayers may not want to wait until the end of the year to make
contributions and forgo the accruals on that year's contribution. Some
interviewees suggested basing eligibility on the previous year's
modified AGI, which taxpayers would already know and could then use to
better plan their contributions over the upcoming year and avoid
contribution errors.[Footnote 52]
Nondeductible contributions to traditional IRAs pose their own
challenges for taxpayers because of recordkeeping needs. Interviewees
said that taxpayers may find it difficult or forget to track the basis
of nondeductible contributions over time in part because these
contributions do not appear on the Form 1040. They added that taxpayers
who did not complete the supplemental Form 8606 to track their
nondeductible contributions may find it challenging to determine the
taxable amount of their distribution. Some may potentially pay tax on
the full distribution amount rather than their taxable basis, while
others face the burden of trying to locate the information needed to
determine the taxable amount and filing an amended return.
Representatives suggested that taxpayers may need more IRS help to
understand how to report and track nondeductible contributions to
traditional IRAs. Suggested options include clarifying the tax return
and Form 8606 and related guidance on tracking the basis for
nondeductible contributions, conducting research to determine where
taxpayer errors are occurring and developing corrective actions, and
implementing a minimum threshold for requiring basis calculation to
reduce taxpayer burden in making complicated calculations for small
distribution amounts.
Challenges with IRA Distribution Rules:
On the distribution end, some taxpayers may be confused about which IRA
distributions are taxable or subject to penalty, and older taxpayers in
particular may not understand when they must begin required minimum
distributions from traditional IRAs. Financial industry organization
and advisor representatives we interviewed agreed that IRA distribution
rules pose challenges for taxpayers trying to navigate on their own
without the help of a tax advisor. As more people contribute and roll
over pension amounts to IRAs and the population ages, more taxpayers
will have to figure out how to navigate IRA distribution rules. Whereas
taxpayers can undo various contribution errors, distribution errors
cannot be undone and can trigger taxes and penalties.
IRS's NRP estimates show that about 15 percent of those with
traditional IRA distributions misreport their distributions. According
to one representative we interviewed, some taxpayers initially forget
to report traditional IRA distributions to IRS in part because
retirement income is not taxable in some states. Other taxpayers make
mistakes in determining the taxable portion of their distributions
because of their original failure to track the basis for nondeductible
contributions. Interviewees viewed Roth IRAs as less challenging for
taxpayers because these distributions are generally tax-free in
retirement.
Even though many owners plan to hold their IRAs until retirement age,
those who take withdrawals before age 59½ face an additional 10 percent
penalty unless they qualify for an exception. This can be a costly
mistake, and IRS's AUR program assessed 38,000 taxpayers a total of
$61.1 million in taxes and penalties on early withdrawals in 2004. As
more exceptions have been added, giving individuals more latitude to
tap their IRAs before retirement, taxpayers may be challenged to
understand what the penalty exceptions are and that IRAs have no
general hardship exception.
* According to IRS officials, rule exceptions created through late or
retroactive legislation, although meant to benefit taxpayers, can
create challenges for IRS to timely prepare guidance and update IRA-
related forms and publications.
* Another interviewee said that taxpayers could be easily confused
about how allowed exceptions to the early distribution rules differ
between IRAs and employer-sponsored retirement plans. Interviewees
disagreed on whether IRA early distribution rules should be conformed
across different types of retirement plans. Some representatives said
that differences among plans made sense, while other interviewees said
that the complexity introduced by different rule exceptions for
different types of retirement plans confuses taxpayers and conforming
the early distribution rules would be beneficial.
* One interviewee said that some taxpayers make mistakes when taking
early distributions from Roth IRAs because qualified distributions
within the 5-year holding period for a Roth IRA, while not subject to
the 10 percent penalty, are still subject to taxation. Moreover, a
taxpayer taking an early distribution from a Roth IRA has to calculate
the taxable portion of distribution and that requires recordkeeping of
all contributions and earnings for the account.
* One interviewee said that taxpayers were sometimes confused about how
custodians report reasons for early distributions to IRS on the Form
1099-R. One representative suggested that Publication 590 could better
explain to taxpayers that IRA custodians are only obligated to report
to IRS whether an early withdrawal was taken, not whether the early
withdrawal qualified as an exception to the 10 percent penalty rule. In
addition, some IRA custodians suggested that to reduce taxpayer and
custodian confusion about temporary or newly enacted qualified
exceptions, IRS could designate a special code, such as for hurricane
relief or charitable giving, that custodians could use to complete the
Form 1099-R until further guidance could be developed.
Financial industry organization and advisor representatives generally
agreed that the required minimum distribution rule for traditional IRAs
was particularly challenging for older taxpayers in terms of both
determining the timing of the first distribution and calculating the
correct amount. For example, the carryover date for the first
distribution, April 1, does not coincide with the filing deadline of
April 15, and some taxpayers may not realize that subsequent
distributions must be done by December 31. To help taxpayers comply
with the rule, in 2002 IRS issued uniform tables to simplify the
calculation and effective for 2003 required that custodians notify
taxpayers through a check box on the Form 5498 that the taxpayers are
required to take a distribution in the following year. Even with the
added service, the complexity of the required minimum distribution rule
is challenging for taxpayers to navigate.
* Representatives said that the age of 70½ was a confusing concept for
taxpayers. Although IRS's tables for calculating each year's minimum
distribution were updated in 2002 to reflect current life expectancy,
the required beginning age of 70½ has been in place since IRAs were
created in 1974. Although some suggested changing the required minimum
distribution rule, one representative noted that changing the age,
which likely benefits the taxpayer through simplification, would likely
create some burden for financial institutions to adjust their
information technology systems.
* Interviewees also suggested that IRS could help taxpayers comply with
required minimum distribution rules by developing an online tool on
IRS's Web site to help taxpayers calculate the correct minimum
distribution amounts or directly notifying taxpayers approaching age
70½ that they will be subject to the required minimum distribution
rule.
* Some representatives we interviewed expressed concern that the 50
percent penalty on minimum distributions not taken was harsh and that
taxpayers may not understand how to request that IRS waive the penalty
for reasonable errors. Through tax year 2004, IRS directed taxpayers to
pay the penalty first and then request a waiver to get the penalty
refunded. In tax year 2005, IRS dropped the requirement for a taxpayer
to pay first to request a waiver. For tax year 2007, IRS revised the
instructions for Form 5329--the form for reporting additional taxes due
on IRAs and other tax-favored accounts--to clarify that a taxpayer is
to provide documentation explaining the issue and does not have to pay
the penalty in advance to request a waiver.
* Whereas IRA custodians provide educational assistance and notice to
the original taxpayer that the required minimum distribution rule
applies for the coming year, beneficiaries inheriting IRAs are likely
to be less prepared to deal with required distributions. According to
interviewees, taxpayers do not always keep beneficiary information up-
to-date, and both taxpayers and their advisors are learning the
different distribution rules for IRAs inherited by spouses versus other
beneficiaries.
Challenges with IRA Rollover Rules:
Interviewees said that some taxpayers may face challenges when they
periodically rollover their IRAs or transfer money from a pension plan
or an IRA into another IRA. Transfers--where IRA funds are shifted
directly from one IRA custodian to another--are not always available,
and taxpayer mistakes in completing rollovers--where the taxpayer
receives a distribution from the first IRA and must contribute the
amount to a new IRA--can trigger taxes and penalties. Failed rollovers
are subject to the 10 percent early withdrawal penalty if the taxpayer
is under age 59½ and the taxpayer's retirement savings would no longer
be eligible for tax-preferred treatment. As increasing amounts of
pension assets are rolled over into IRAs, more taxpayers may experience
challenges when moving money between accounts.
* For transfers between financial institutions, some taxpayers may face
a challenge in that not all financial institutions offer this option or
are able to systematically handle trustee-to-trustee transfers. The
automated system that mutual fund companies use to transfer assets
differs from the system brokers use to transfer securities, according
to these representatives. They added that system enhancements are being
explored, but currently, transfer options may be limited for some
taxpayers who wanted to directly transfer IRA assets.
* Interviewees also pointed out that some taxpayers preferred not to
directly transfer their IRAs in part because some may want to use the
funds as a temporary loan during the 60-day window in which they are to
complete a rollover. This situation can be problematic, according to
some representatives, because taxpayers might cash out their funds or
miss the deadline to complete the rollover. Other interviewees said
that the 60-day rollover window benefits taxpayers and may increase
savings because it makes assets seem more accessible, which may
alleviate some apprehension about setting assets aside in the IRA.
Taxpayers who miss the 60-day window may qualify for an automatic
waiver for custodian mistakes in depositing funds or providing
erroneous advice. Others can pay to request a private letter ruling
from IRS to waive the deadline, but IRS has typically not granted
waivers for taxpayers who knew or should have known of the 60-day
deadline but had no intention of rolling over the funds by the
deadline.
Options Include Enhanced IRS Service to Help Taxpayers Better
Understand IRA Rules and Regulatory or Legislative Changes to Simplify
Some IRA Rules:
To address the various challenges facing taxpayers in complying with
IRA rules, options suggested by interviewees and others ranged from
improvements in IRS service to help taxpayers better understand the
current rules to broader regulatory and legislative changes to simplify
the rules governing IRAs.
Enhancing IRS's taxpayer service efforts, such as clarifying and
revising IRS Publication 590, could help strengthen compliance with IRA
rules by helping taxpayers better understand the rules and avoid
unintentional errors. However, these efforts are not easily assessed in
terms of their effect on improving compliance. IRS officials said that
even though they are able to receive some feedback from customers about
how to improve IRA-related forms and publications, they added that it
was hard to gather data on their effectiveness, especially when changes
are constantly being made. Financial representatives and others we
interviewed suggested additional opportunities to clarify guidance and
offer new tools to help taxpayers with challenging IRA rules. As
recommended by TIGTA, IRS plans to clarify the IRA deduction worksheet
to instruct taxpayers over age 70½ that they cannot claim the
deduction. As discussed above, IRS could do more to help taxpayers
better understand that the total contribution limit applies across
traditional and Roth IRAs and is not a limit for each IRA type.
IRS also could explore developing new tools to aid taxpayers in
complying with complex IRA rules. For the required minimum distribution
rule, interviewees suggested that IRS offer an online calculator. IRS
officials cautioned that offering an online calculator is not cost
free, estimating that developing the tool could cost about $250,000.
Another option could be to expand custodian reporting--beyond simply
requiring custodians to notify taxpayers that they are subject to the
distribution rule--to requiring that custodians calculate and report
the minimum distribution amount per account. Options requiring
additional reporting by IRA custodians could improve information
available to help taxpayers comply with IRA rules and to help IRS
detect noncompliance, but such options pose trade-offs in terms of the
added reporting burden for those parties and costs for IRS to use the
information.
Beyond improved IRS service to help educate taxpayers about current IRA
rules, financial representatives and advisors we interviewed frequently
mentioned simplifying IRA rules through legislative changes as an
option to strengthen taxpayer compliance. While not an easy task,
simplification could help prevent unintentional taxpayer errors and
allow fewer opportunities to hide intentional noncompliance. Modifying
the IRA rules, while intended to benefit taxpayers, could also create
unintended confusion.
* Interviewees said that the Pension Protection Act of 2006 provision
allowing charitable contributions of up to $100,000 to be made directly
from IRAs to charities as tax-free distributions raised many questions
from IRA owners and custodians, as well as charities, about how to
implement the transaction, since the provision had become effective
before IRS could develop guidance and was due to expire in 2007.
* Another option--basing IRA eligibility on the previous year's
modified AGI--may place a burden on taxpayers to track their modified
AGI from the previous year, pose a challenge to IRS to match taxpayer
information across years through its automated systems, and introduce
additional confusion by deviating from other retirement plan rules,
which use current year data. While some interviewees favored this
option, one interviewee expressed concern that this change could
introduce situations where some taxpayers may be unable to contribute
to any retirement plan for that year.[Footnote 53]
Broad IRA legislative options, such as eliminating limits on income
eligibility for traditional IRA contribution deductions or Roth IRA
contributions or eliminating the required minimum distribution rule,
could greatly simplify the rules for some taxpayers, such as older
taxpayers who do not need to draw down their IRAs to pay for retirement
needs. Such options, however, would certainly reduce federal revenue
and with no certainty that more people would take advantage of IRAs to
save for retirement.[Footnote 54]
A full evaluation of options to simplify the taxation of retirement
savings is beyond the scope of this report, which focuses on the
challenges taxpayers face with the current key rules for traditional
and Roth IRAs. The National Taxpayer Advocate has suggested simplifying
the rules across IRAs and employer pension plans to reduce complexity
and encourage participation.[Footnote 55] In 2004, the National
Taxpayer Advocate's Annual Report to Congress recommended that
retirement savings provisions be simplified. The report cited that the
various types of retirement savings vehicles, while intended to help
taxpayers save for retirement, also created complexity and redundancy
in the tax law because of their different rules regulating eligibility,
contribution limits, withdrawals, and other transactions. Another
approach is to reexamine traditional and Roth IRA rules in the context
of broader tax reform when considering fundamental decisions about how
to make tax investment and saving.[Footnote 56]
Conclusions:
The volume and complexity of IRA rules create a maze where taxpayers
may intentionally or unintentionally wander out of compliance with the
rules, triggering taxes and penalties. As more taxpayers take advantage
of IRAs to contribute funds for retirement or preserve pension
rollovers, and with an aging population beginning to tap their
retirement savings, taxpayers will encounter growing challenges in
complying with the myriad of IRA rules. Sustained attention to taxpayer
service and education will be key to helping taxpayers comply with IRA
rules and avoid unnecessary penalties on distributions before
retirement age or late distributions for older taxpayers owning
traditional IRAs. IRS's service efforts, such as Publication 590, have
been a positive step toward strengthening taxpayer compliance.
Nevertheless, those using IRAs make basic mistakes in figuring out how
much to contribute and how much in taxes they may owe on distributions.
To address the challenges taxpayers face with do-it-yourself retirement
saving using IRAs, IRS has some opportunities to clarify its IRA
guidance and possibly offer new tools to help taxpayers stay on a
compliant path. Even with added IRS service for taxpayers, some IRA
rules, notably the required minimum distribution rule, may need
legislative or regulatory simplification to best help taxpayers
navigate their way. Broader options to simplify IRA contribution and
distribution rules have implications for both federal revenue and
taxpayer choice for tax-preferred retirement saving, and policymakers
could consider IRA rule changes in the context of broader tax reform.
Recommendations for Executive Action:
To help address the challenges facing taxpayers in complying with IRA
rules, we recommend that the Commissioner of Internal Revenue take the
following two actions:
* Clarify guidance and outreach materials to help taxpayers better
understand that the combined IRA contribution limit applies across all
traditional and Roth IRAs.
* Identify administrative options to improve compliance with the
minimum required distribution rule, including additional taxpayer
guidance or information reporting, and work in consultation with
Treasury on regulatory or legislative strategies to strengthen
compliance with the rule.
Agency Comments:
In comments on a draft of this report (which are reprinted in app.
III), IRS said that our report fairly represents the rules and
challenges that apply to IRAs and that IRS is committed to providing
clear information to taxpayers about IRA rules. IRS agreed to take
actions consistent with both of our recommendations. Specifically, IRS
will continue to find opportunities to provide taxpayers with a better
understanding of the combined limit rule and explore ways to improve
compliance with the required minimum distribution rule, including
working with Treasury or seeking legislative options. Treasury provided
technical comments on a draft of this report, which we incorporated as
appropriate.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from its issue date. At that time, we will send copies to the Chairman
and Ranking Member, House Committee on Ways and Means; the Secretary of
the Treasury; the Commissioner of Internal Revenue; and other
interested parties. We will also make copies available to others upon
request. In addition, this report will be available at no charge on the
GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions about this report, please
contact me at (202) 512-9110 or brostekm@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. Key contributors to this report are
listed in appendix IV.
Signed by:
Michael Brostek:
Director, Tax Issues Strategic Issues Team:
[End of section]
Appendix I: Scope and Methodology:
The objectives of this report are to (1) provide an overview of key
individual retirement account (IRA) contribution, distribution, and
other rules and describe how the Internal Revenue Service (IRS)
educates taxpayers on these rules; (2) describe what IRS knows about
the extent of noncompliance for IRA transactions reported on tax
returns; and (3) describe the challenges taxpayers face with key IRA
rules and some options to strengthen taxpayer compliance. This report
focuses on traditional and Roth IRAs set up by individuals to save on
their own.[Footnote 57] Specifically, we relied on key rules governing
contributions and distributions for tax-deferred traditional IRAs and
after-tax Roth IRAs. Accordingly, we did not review every IRA rule in
its entirety. Throughout this engagement, we relied upon IRS
Publication 590 as our primary source for understanding traditional IRA
and Roth IRA rules.
Objective 1: Provide an Overview of Key IRA Contribution, Distribution,
and Other Rules:
To provide an overview of key IRA rules, we relied primarily on IRS
Publication 590, which explains the rules that taxpayers are to follow
in contributing to, and receiving distributions from, an IRA. Specific
rules depend on account type. We also spoke with IRS and Department of
the Treasury (Treasury) officials and reviewed reports from the
Congressional Research Service, the Congressional Budget Office, the
Investment Company Institute, and others. We also reviewed laws and
regulations related to IRAs. For background about IRAs, we spoke with
officials in the Research, Analysis and Statistics unit from Statistics
of Income (SOI), reviewed SOI bulletin articles, and compiled
statistics from SOI data.
To describe how IRS educates taxpayers in complying with IRA rules, we
reviewed relevant documents and interviewed relevant agency officials
who were identified for us by IRS, including officials from the
following divisions: Wage and Investment (W&I); Tax Exempt and
Government Entities (TE/GE); and Research, Analysis and Statistics. In
addition, we spoke with the Taxpayer Advocate Service, an independent
office within IRS. Within W&I, we spoke with officials from Media and
Publications, Stakeholder Partnerships Education and Communication,
Accounts Management, and Field Assistance. Within TE/GE, we spoke with
officials from Employee Plans. We also reviewed other guidance, such as
the IRS Web site and various IRS publications.
Objective 2: Describe What IRS Knows about the Extent of Noncompliance
for IRA Transactions Reported on Tax Returns:
To describe what IRS knows about the extent and types of taxpayer
misreporting of IRA transaction on tax returns, we reviewed
publications and documents, interviewed IRS officials, and used the
2001 National Research Program (NRP)--IRS's most recent study of
individual taxpayer compliance--to estimate the extent of taxpayer
misreporting with traditional IRA deductible contribution rules and
traditional IRA taxable distribution rules. Specifically, taxpayers
report these transactions on the Form 1040 individual income tax
return.[Footnote 58] We provide the margin of error based on 95 percent
confidence for estimates from the NRP samples of individual tax
returns. We also analyzed data on taxpayer misreporting supplied by the
Math Error program and the Automated Underreporter (AUR) program. The
Math Error program electronically checks for obvious math errors as tax
returns are processed, and the AUR program matches taxpayer returns
with IRA custodian-reported information.[Footnote 59] We followed our
guidance for assessing the reliability of computerized databases in
using these data sources, and determined that the data are reliable for
the purposes of this engagement.
Objective 3: Describe Challenges That Taxpayers Face with Key IRA Rules
and Options for Strengthening Taxpayer Compliance:
To describe the challenges taxpayers face with key IRA rules and some
options for strengthening taxpayer compliance with these rules, we
reviewed prior GAO reports, IRS documents from its enforcement and
service programs that address IRA rules, and documents from other
organizations, such as IRS Publication 590 and reports issued by
financial industry organizations and research agencies. We also spoke
with IRS officials and financial industry organization and advisor
representatives knowledgeable about IRAs who provide tax planning
advice or serve as IRA custodians to get their perspectives on
challenges related to IRA compliance and how those challenges could be
addressed. Specifically, we interviewed representatives from financial
industry organizations, including the Securities Industry and Financial
Markets Association; Investment Company Institute, which represents the
mutual fund industry; Financial Planning Association; American Bankers
Association; American Institute of Certified Public Accountants; and
AARP.[Footnote 60]
We conducted two rounds of interviews with financial industry
organizations and advisor representatives. In our first round of
interviews, we asked open-ended questions to obtain information about
the range of challenges and options for strengthening compliance.
Because we asked open-ended questions, the frequency of our
interviewees' responses is not comparable. Therefore, we report
responses without reporting the total number of officials or
representatives associated with each response. After analyzing the
information gathered to identify some common challenges raised by the
interviewees, we used a standard set of questions in a second round of
interviews with the representatives to try to verify responses and
obtain additional context for the challenges and options mentioned,
such as whether the challenges were major or frequent or whether an
option might impose significant burden on taxpayers or IRA custodians.
We also shared the list of challenges with IRS and Treasury to obtain
concurrence about taxpayer challenges. Finally, we limited the
discussion of challenges and options identified to only those related
to the key IRA rules reviewed in this report. These challenges and
options are not exhaustive nor are the trade-offs associated with each
option. Many of the options are concepts, rather than fully developed
proposals with details on how they would be implemented.
We conducted this performance audit from March 2008 through August 2008
in accordance with generally accepted government auditing
standards.[Footnote 61] Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide
a reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.
[End of section]
Appendix II: IRS Forms Used to Report Individual Retirement Account
Information:
Table 7:
Form number: 1040 & 1040A;
Prepared by: Account owner;
Submitted to: IRS;
Copied to: NA;
Purpose related to IRAs: To report:
* Deductible contributions to a traditional IRA from Form 5498 (1040
line 32, 1040A line 17),;
* Summary of distribution information from Form 8606 or Form 1099-R
(1040 line 15, 1040A line 11),;
* Additional tax on an IRA (1040 line 60; from Form 5329),;
* Retirement savings contribution credit from Form 8880 (1040 line 51,
1040A line 32), or;
* Taxable compensation from Form W-2 (1040 and 1040A line 7).
Form number: 8606;
Prepared by: Account owner;
Submitted to: IRS;
Copied to: NA;
Purpose related to IRAs: To report one of four actions taken during the
year:
* Nondeductible contribution to traditional IRA (Part I);
* Distribution from a Simplified Employee Pension (SEP) or Savings
Incentive Match Plan for Employees (SIMPLE) IRA or a traditional IRA
with basis greater than zero (Part I);
* Conversions from traditional, SEP, or SIMPLE IRA to a Roth IRA (Part
II);
* A distribution from a Roth IRA (Part III); Summary information is
reported on 1040 line 15 or 1040A line 11; The penalty for not filing
an 8606 when required is $50. The penalty for overstating a
contribution is $100.
Form number: 5329;
Prepared by: Account owner;
Submitted to: IRS;
Copied to: NA;
Purpose related to IRAs: To report additional tax related to an IRA
being paid because of;
* Early, unexpected, distribution from an IRA (Part I);;
* Excess contribution made to a traditional or Roth IRA.(Parts III &
IV); or;
* Excess accumulation in an IRA for account holders subject to minimum
required distributions (Part VIII); Summary information is reported on
1040 line 60.
Form number: 8880;
Prepared by: Account owner;
Submitted to: IRS;
Copied to: NA;
Purpose related to IRAs: For lower-income taxpayers to claim a tax
credit of up to 50 percent of their contribution to a traditional or
Roth IRA (8880 line 1). Summary information is reported on 1040 line 51
or 1040A line 32.
Form number: W-4P;
Prepared by: Account owner;
Submitted to: Financial institution;
Copied to: NA;
Purpose related to IRAs: To request no withholding or additional
withholding on distributions from a traditional IRA (other than
eligible rollover distributions).
Form number: W-2;
Prepared by: Employer;
Submitted to: IRS;
Copied to: Wage earner, Social Security Administration, state/local tax
department;
Purpose related to IRAs: To document the following:
* Earned income (Box 1). Money to be contributed to an IRA must come
out of taxable compensation;
* Whether the taxpayer is covered by an employer- sponsored retirement
plan (Box 13), which affects deductibility for a traditional IRA; Box 1
taxable compensation is reported on 1040 and 1040A line 7.
Form number: 1099-R;
Prepared by: Financial institution;
Submitted to: IRS;
Copied to: Account owner, state/local tax department;
Purpose related to IRAs: To report a distribution from an IRA to an
account owner. Information reported includes the gross value of the
distribution, its taxable amount, and whether any tax was withheld. The
form also includes a distribution code that reports the type of
distribution (normal, early with qualified exception, early without
qualified exception, withdrawn contributions, etc.) If a distribution
is taxable, it is reported on 1040 line 15 or 1040A line 11.
Form number: 5498;
Prepared by: Financial institution;
Submitted to: IRS;
Copied to: Account owner;
Purpose related to IRAs: To report the fair market value and
contribution amounts to an IRA by an account owner. Information
reported includes the value of the contribution and its type: normal,
rollover, Roth conversion, recharacterization, or Roth contribution.
The form also includes a check box that indicates whether a required
minimum distribution is due that year. Summary information is reported
on 1040 line 32 or 1040A line 17.
Source: GAO analysis of IRS data.
Notes: Data are from IRS Publication 590. NA = not applicable.
[End of table]
[End of section]
Appendix II: Comments from the Internal Revenue Service:
Department Of The Treasury:
Internal Revenue Service:
Washington, D.C. 20224:
Deputy Commissioner:
July 30, 2008:
Mr. James R. White:
Director Tax Issues:
Strategic Issues Team:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. White:
We appreciate the opportunity to comment on the Government
Accountability Office's draft report on: Individual Retirement
Accounts: Additional IRS Actions Could Help Taxpayers Facing Challenges
in Complying with Key Tax Rules (GAO-08-654). The report fairly
represents the rules and challenges that apply to Individual Retirement
Accounts (IRAs) as well as the size of the IRA universe. Our comments
are shown below:
* The Internal Revenue Service (IRS) is committed to providing clear
information to taxpayers about the rules that apply to traditional and
Roth IRAs. The IRS will continue to look for opportunities to provide
taxpayers a better understanding of the combined IRA contribution limit
for traditional and Roth IRAs, and the required minimum distribution
rule.
* The IRS will consider ways to improve compliance with the IRA minimum
distribution rule and consult with the Department of the Treasury to
determine whether there are regulatory or legislative changes that can
be made that would reduce noncompliance.
Thank you for your interest in this area. If you have questions
concerning this response, please contact Steven T. Miller,
Commissioner, Tax Exempt and Government Entities, at (202) 283-2500.
Sincerely,
Signed by:
Linda E. Stiff
[End of section]
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Michael Brostek, (202) 512-9110 or brostekm@gao.gov:
Acknowledgments:
In addition to the contact named above, MaryLynn Sergent, Assistant
Director; Elizabeth Fan; Evan Gilman; Rob Malone; Donna Miller; Karen
O'Conor; Cheryl Peterson; Matthew Reilly; Sam Scrutchins; Walter Vance;
and Jennifer Li Wong made key contributions to this report.
[End of section]
Glossary:
Active Participant:
Status of an individual's participation in an employer-sponsored
retirement plan. Typically, the employer will indicate on the
individual's Form W-2 if the individual is an active participant by
checking the Retirement Plan box.
Basis:
The accumulated nondeductible contributions in a traditional IRA.
Compensation:
For IRA purposes includes wages/salaries/tips, commissions, self-
employment income, alimony, separate maintenance, and nontaxable combat
pay. IRA contributions must come from taxable compensation received
during the year.
Contribution:
An amount, subject to limits, deposited into an IRA.
Deductible Contribution:
A contribution that allows tax deferral on investment earnings until
retirement distribution with an up-front tax deduction for
contributions by eligible taxpayers depending on pension coverage and
income. Annual contributions are subject to a total limit.
Nondeductible Contribution:
An after-tax contribution to a traditional IRA that is not eligible for
up-front tax deduction. Nondeductible contributions are not subject to
an income limit but are subject to the total limit.
Roth Contribution:
An after-tax contribution to a Roth IRA by eligible taxpayers. Roth IRA
contributions are subject to a limit based on a taxpayer's income and
filing status.
Excess Contribution:
A contribution made in excess of eligible amount for the year, which is
subject to a 6 percent additional tax to penalize excess contributions.
Conversion:
A specific type of rollover in which funds on deposit in a traditional
IRA are transferred to a Roth IRA.
Distribution:
An amount paid out from an IRA. Distributions from traditional IRAs are
taxable subject to a recovery of basis for a nondeductible IRA, and
Roth IRAs are generally tax-free.
Early Distribution:
An amount issued to an account owner from an IRA during a year in which
the account owner has not reached age 59-½, for reasons such as cost of
medical insurance for the unemployed or purchase or rebuilding of a
first home.
Eligible Rollover Distribution:
A distribution made to an account owner that is eligible to be
contributed via rollover to another IRA or qualified plan.
Required Minimum Distribution:
The minimum amount that must by distributed to an account owner each
year beginning in the year when the account owner reaches age 70-½. The
required minimum contribution is calculated uniquely for each account
based on account balance and life expectancy.
Excess Accumulation:
A condition that occurs when an account owner is age 70-½ or older and
does not receive distributions during the year that equal at least the
required minimum distribution. Excess accumulations are subject to a 50
percent penalty.
IRA (Individual Retirement Account):
An account for tax-deferred retirement savings that is controlled by
individuals, not employers. The term IRA, also known as individual
retirement arrangement, also includes individual retirement annuities.
Roth IRA:
An IRA that accepts after-tax contributions subject to limits and
allows tax-free withdrawals.
SEP IRA:
An arrangement for an employer to make deductible contributions to a
traditional IRA (a Simplified Employee Pension or SEP IRA) set up for
the employee to receive contributions. Generally, distributions from
SEP IRAs are subject to the withdrawal and tax rules that apply to
traditional IRAs.
SIMPLE IRA:
An IRA that is set up to receive contributions to an employee pursuant
to a Savings Incentive Match Plan for Employees (SIMPLE), which is
available to qualifying small businesses.
Traditional IRA:
An IRA that accepts both deductible and nondeductible contributions,
subject to limits, and makes taxable distributions.
Modified Adjusted Gross Income (AGI):
The income level referenced to establish eligibility for making
contributions to a traditional IRA or a Roth IRA. This amount is
calculated via a worksheet that is specific to the plan type to which
the taxpayer wants to contribute.
Phaseout Range:
The range of modified AGI during which the eligible contribution amount
phases down from the maximum amount to zero.
Recharacterization:
A process by which an ineligible contribution is moved, before the tax-
filing deadline, to an account that is eligible to receive it.
Rollover:
The process by which funds on deposit in a qualified employer plan or
another IRA are transferred to an IRA.
Direct Rollover:
A rollover that is transferred, tax-free, directly from one trustee to
another with no distribution being made to the account owner.
Trustee:
A financial institution that maintains an account owner's IRA.
Withholding:
The amount held back by a trustee when a distribution is made to an
account owner; amount of withholding depends on type of distribution.
[End of section]
Footnotes:
[1] IRAs were enacted as part of the Employee Retirement Income
Security Act of 1974 (Pub. L. No. 93-406). The term IRA, also known as
individual retirement arrangement, also includes individual retirement
annuities.
[2] Victoria L. Bryant, "Accumulation and Distribution of Individual
Retirement Arrangements, 2004," Statistics of Income Bulletin, vol. 27,
no. 4 (Washington, D.C.: Spring 2008).
[3] Peter Brady and Sarah Holden, "The U.S. Retirement Market, 2007,"
Research Fundamentals, vol. 17, no. 3 (Washington, D.C.: Investment
Company Institute, July 2008).
[4] According to estimates by the Joint Committee on Taxation, IRAs
cost the federal government $15.5 billion in revenue losses in 2007.
[5] Tax preferences--which are legally known as tax expenditures--
result in forgone revenue for the federal government. For more
information on revenue loss measurement, see GAO, Government
Accountability and Performance: Tax Expenditures Represent a
Substantial Federal Commitment and Need to Be Reexamined, GAO-05-690
(Washington, D.C.: Sept. 23, 2005).
[6] Taxpayers ineligible for the deduction because of income
limitations can make nondeductible contributions to take advantage of
the deferral on investment earnings.
[7] See GAO, National Saving: Current Saving Decisions Have Profound
Implications for Our Nation's Future Well-Being, GAO-06-628T
(Washington, D.C.: Apr. 6, 2006), and National Saving: Answers to Key
Questions, GAO-01-591SP (Washington, D.C.: June 2001), for more
information on measuring personal saving. Economists disagree about
whether tax incentives have been or could be effective in increasing
the overall level of personal saving.
[8] Pub. L. No. 105-34 (1997).
[9] For more information on employer-sponsored IRAs, see GAO,
Individual Retirement Accounts: Government Actions Could Encourage More
Employers to Offer IRAs to Employees, GAO-08-590 (Washington, D.C.:
June 4, 2008).
[10] GAO, Individual Retirement Accounts: IRS Enforces Some but Not All
Rules, and Opportunities Exist to Strengthen Taxpayer Compliance, GAO-
07-1059SU (Washington, D.C.: Sept. 19, 2007). Designated by IRS as
Limited Official Use Only, our September 2007 report contains two
additional recommendations to improve IRS enforcement and research
related to IRA rules.
[11] This report does not address employer-based individual retirement
arrangements, such as SEPs or SIMPLEs; SEP and SIMPLE IRAs are subject
to different rules and guidance than traditional and Roth IRAs.
[12] For Roth IRAs, contributions are not deductible, and distributions
are generally tax-free and are not reported on the 1040 tax return.
[13] The discussion of these two programs is a public version of the
discussion in our more comprehensive September 2007 report that
contained sensitive tax enforcement information. Specific details
regarding the nature of these automated enforcement programs that IRS
considered sensitive were removed.
[14] This reflects the additional audit work performed for this report
since our September 2007 report.
[15] Some taxpayers may own more than one type of IRA.
[16] For more information on IRA participation rates, see Congressional
Budget Office, Utilization of Tax Incentives for Retirement Saving:
Update to 2003 (Washington, D.C.: Mar. 2007).
[17] See glossary for list of IRA terms and app. II for IRS forms
related to IRAs. Information in glossary is from IRS Publication 590.
[18] Eligibility based on taxpayer compensation generally includes
wages, salaries, professional fees, bonuses, and other amounts
taxpayers receive for providing personal services and from commissions,
self-employment income, alimony and separate maintenance payments
taxpayers receive, and nontaxable combat pay. Taxable compensation does
not include earnings and profits from property, pension or annuity
income, deferred compensation received, income from partnerships for
which the taxpayer did not provide services that are material income-
producing factors, and any amounts excluded from income, such as
foreign earned income and housing costs.
[19] Modified AGI is calculated by taking AGI and adding back certain
items, such as foreign housing deductions and student loan deductions.
[20] The phaseout range is the range of modified AGI during which the
eligible deductible contribution amount phases down from maximum amount
to zero.
[21] In the example, the taxpayer cannot apply the 2008 contributions
to an earlier year even if the taxpayer contributed less than the
maximum amount in the earlier year.
[22] Taxpayers are required to complete Form 8606 if they received a
distribution from a traditional IRA and have ever made nondeductible
contributions to any of their traditional IRAs. Using the form, they
figure the nontaxable distributions for that year and their total IRA
basis for that and earlier years.
[23] The 5-year period begins with the first taxable year for which a
contribution was made to the Roth IRA. Early distributions within 5
years of contributing to the account may be subject to income and
additional taxes. Roth IRAs held for 5 years are also tax-free if the
distribution is (1) made because a taxpayer is disabled, (2) made to
the beneficiary of an estate after the taxpayer's death, or (3) for the
purchase or building of a first home.
[24] By law, the nine exceptions for early distributions from a
traditional IRA are for (1) unreimbursed medical expenses exceeding 7.5
percent of AGI, (2) cost of medical insurance for the unemployed, (3)
the disabled, (4) a beneficiary of a deceased IRA owner, (5)
distributions in the form of an annuity or a series of substantially
equal payments, (6) qualified higher education expenses, (7) purchase
or building of a first home, (8) IRS levy, and (9) qualified military
reservist distribution. See IRS Publication 590 for more on these
exceptions for traditional and Roth IRAs.
[25] The exception is that a taxpayer with a spouse more than 10 years
younger can use a uniform joint life expectancy table. IRS Publication
590 explains the minimum required distribution rule and how to use the
life expectancy tables to calculate the minimum distribution.
[26] Before 2006, the fee was $95. Effective February 1, 2006, the fee
is $500 for rollovers less than $50,000, $1,500 for those $50,000 to
less than $100,000, and $3,000 for $100,000 and larger rollovers.
[27] The Tax Increase Protection and Reconciliation Act of 2005, Pub.
L. No. 109-222 (2006), enacted in May 2006, removed the income
restriction for Roth IRA conversions after December 31, 2009. The
Pension Protection Act of 2006, Pub. L. No. 109-280 (2006), permits
conversion to Roth IRAs from any kind of plan beginning in 2008.
[28] This income limit for conversions was enacted in 1997.
[29] Distributions from a traditional IRA may be partly taxable if a
taxpayer has basis with nondeductible contributions that were already
taxed.
[30] The taxpayer must file Form 8606 even if no tax return was filed
for the year, and the penalty for failure to file Form 8606 is $50.
[31] Early distributions within the first 5 years of setting up a Roth
IRA and before age 59½, unless an exception applies, are subject to the
10 percent penalty.
[32] This report focuses on what IRS knows about taxpayer misreporting
of IRA transactions on tax returns. Our separate Limited Official Use
Only report discusses more fully how IRS enforces key IRA rules.
[33] NRP estimates of the number of taxpayers by unique tax returns and
not by unique taxpayers. It is possible that within one tax return, two
taxpayers are noncompliant.
[34] We are 95 percent confident that from 11.8 percent to 17.8 percent
did not accurately report their traditional IRA deductions.
[35] Estimate has a margin of error of less than or equal to (+/-)
124,057.
[36] We are 95 percent confident that from 7.9 percent to 13.3 percent
overstated their traditional IRA deductions. We are 95 percent
confident that from 2.8 percent to 6.5 percent understated their
traditional IRA deductions.
[37] Dollar estimate has a margin of error of less than or equal to (+/
-) $192 million.
[38] We are 95 percent confident that from 12.7 percent to 16.6 percent
did not accurately report their traditional IRA distributions.
[39] Estimate has a margin of error of less than or equal to (+/-)
220,026.
[40] We are 95 percent confident that from 11.8 percent to 15.7 percent
underreported their traditional IRA distributions. We are 95 percent
confident that from 0.5 percent to 1.4 percent overreported their
traditional IRA distributions.
[41] Dollar estimate has a margin of error of less than or equal to (+/
-) $2.2 billion.
[42] This report uses IRS enforcement data to provide perspective on
the types and magnitude of mistakes taxpayers make in reporting IRA
transactions on their tax returns. Our separate Limited Official Use
Only report discusses more fully how IRS enforces IRA rules.
[43] The Internal Revenue Code (I.R.C.) does not provide taxpayers a
right to appeal assessments under math error authority because that
authority generally applies to obvious errors made by taxpayers on
their returns. Instead, the math error notices inform taxpayers that
they may file a claim asking for an abatement if they believe IRS
erred.
[44] I.R.C. § 6213 grants math error authority for issues such as
calculation errors, entries that are inconsistent with or exceed
statutory limits, various omissions of information, or incorrect use of
an IRS table.
[45] For misreported IRA distributions estimated by NRP, we could not
estimate the share covered by the AUR program because IRA distribution
data are included with distributions from other qualified plans.
[46] This figure does not include tax assessments involving larger
dollar value early distribution cases handled by Correspondence
Examinations.
[47] App. I discusses our interview methodology and the various
financial groups we contacted.
[48] Taxpayers over age 70½ cannot contribute to a traditional IRA but
can contribute to a Roth IRA. TIGTA found that 1,826 taxpayers
improperly claimed $4 million in IRA deductions in 2006 for an
estimated loss of revenue of $601,423; in 2007, 1,693 older taxpayers
improperly claimed more than $3.5 million in IRA deductions with an
estimated revenue loss of $530,099.
[49] The maximum income amounts vary across the two IRA types. See
table 2 for traditional IRA deduction eligibility and table 3 for Roth
IRA contribution eligibility. These tables also show the phaseout
ranges for partial eligibility. For both IRA types, eligibility is
limited to taxable compensation.
[50] Active participants for a defined benefit plan include, for
example, employees who decline to participate, those who do not perform
the minimum service to earn a benefit, and those who are not yet
vested.
[51] Taxpayers who overcontribute to any type of IRA can withdraw the
excess plus any earnings to avoid the penalty or pay the penalty and
apply the excess amount as an IRA contribution for a later year.
Recharacterizations, withdrawals, or carryforward to later years of
2008 contributions generally have to be completed by the extended due
date (including extensions) of the taxpayer's 2008 income tax return.
[52] Extending the example, a taxpayer could use the 2008 W-2 to
determine eligibility for 2009 IRA contributions.
[53] Eligibility for traditional IRA contribution deduction is based on
pension coverage and marital filing status in addition to income
limits.
[54] See also Thomas L. Hungerford and Jane G. Gravelle, Individual
Retirement Accounts (IRAs): Issues and Proposed Expansion (Washington,
D.C.: Congressional Research Service, Updated Mar. 10, 2008), and
Thomas L. Hungerford, Saving Incentives: What May Work, What May Not
(Washington, D.C.: Congressional Research Service, Updated Sept. 27,
2007).
[55] National Taxpayer Advocate, 2004 Annual Report to Congress
(Washington, D.C.: Dec. 2004).
[56] GAO, Understanding the Tax Reform Debate: Background, Criteria, &
Questions, GAO-05-1009SP (Washington, D.C.: Sept. 2005).
[57] Issues related to beneficiaries inheriting IRAs were beyond our
scope. Also, this report does not examine employer-based individual
retirement arrangements, such as Simplified Employee Pensions (SEP) or
Savings Incentive Match Plans for Employees (SIMPLE); with the
exception of required minimum distributions, SEP and SIMPLE IRAs are
subject to different rules and guidance than traditional and Roth IRAs.
[58] For Roth IRAs, contributions are not deductible, and distributions
are generally tax-free and are not reported on the 1040 tax return.
[59] The discussion of these two programs is a public version of the
discussion in our more comprehensive September 2007 report that
contained sensitive tax enforcement information. Specific details
regarding the nature of these automated enforcement programs that IRS
considered sensitive were removed.
[60] The American Association of Retired Persons officially changed its
name to AARP in 1999.
[61] This reflects the additional audit work performed for this report
since our September 2007 report.
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