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3 Misleading IRS Forms

Figuring out the tax rules for retirement plans and IRAs is hard enough. It's too bad that some IRS forms make the process even trickier.

A trio of IRS forms can lead you astray regarding proper tax treatment of your retirement benefits.

Form 5498 for inherited IRA: The first is IRS Form 5498, the "information return" your IRA provider must file with the IRS for every single IRA it administers. A copy is also sent to the IRA owner. Filed in the spring each year, the form tells the IRS the name, address, and Social Security number of the owner of the IRA, and what the account was worth at the end of the prior year.

Suppose you are Junior Doe who inherited your mother's IRA when she died in 2017. In 2018 you receive your first Form 5498 for your inherited IRA. The box for "Participant's Name" contains your name and your mother's name. It will read "Junior Doe as beneficiary of Mother Doe," or words to that effect.

Then there's Box 11, "Check if RMD for 2018." That box normally won't be checked for your inherited IRA, nor will the related box 12B ("RMD amount") be filled in. When those spaces are left blank (as they normally are for an inherited IRA), then, at best, there is nothing about this form that alerts you that you are required to take a distribution from the account in 2018--and at worst, you might affirmatively (but erroneously) conclude you are not required to take a distribution because these boxes are left blank.

But the form is misleading. In leaving those boxes blank for an inherited IRA, the IRA provider is just following the IRS instructions telling it how to complete Form 5498: "Until further guidance is issued, no reporting is required for IRAs of deceased participants ..." (emphasis added). The average beneficiary was not likely born knowing he or she would have to take RMDs from an inherited IRA, and--it turns out, thanks to IRS rules--nobody has the responsibility to tell the beneficiary about this obligation. Beneficiaries may not find out until they receive an IRS penalty notice for failure to take an RMD.

Form 5329: Missed RMD "shortfall": If you fail to take a required minimum distribution from your IRA or other retirement plan, you face a 50% "additional tax" (usually referred to as a penalty though it's technically just an excise tax) on the amount of money you were supposed to withdraw but didn't. Fortunately for us forgetful taxpayers, the IRS can waive this penalty. All you need to do is request the waiver, showing that you had reasonable cause to miss the distribution and you have taken reasonable steps to remedy the shortfall.

IRS Form 5329 is used to report the missed RMD, compute the penalty, and/or request a waiver. Even though this is the biggest penalty the IRS can hit you with, it rates only four lines at the very end of Form 5329, in Part IX: Line 52, required distribution for the applicable year; Line 53, amount actually distributed; Line 54, Subtract line 53 from line 52; and Line 55, additional tax (50% of line 54). What could be simpler?

Suppose Tom was required to take $35,000 in 2017 from his IRA (his only retirement account). Due to reasonable cause an error was made and he only took $25,000. So clearly he enters $35,000 on line 52 and $25,000 on Line 53.

Now we come to the big lie. It says on the form right next to Line 54, "Subtract line 53 from line 52." If he does just exactly what the form tells him to do, Tom enters $10,000 on Line 54 ... after all, that is the amount of the "shortfall" in his RMD, the amount he was supposed to take but didn't.

Big mistake. The IRS will now send him a bill for $5,000, which is 50% of the amount Tom has shown on Line 54.

Here's the double secret method Tom should have followed. He should have read the separate instructions for Form 5329, which inform you that, if you can show that any shortfall in the amount of distributions was due to reasonable error, and you are taking reasonable steps to remedy the shortfall, the IRS can waive the penalty. And, say these separate instructions, "If you believe you qualify for this relief, attach a statement of explanation and file Form 5329 as follows. Complete lines 52 and 53 as instructed. Enter 'RC' [reasonable cause] and the amount you want waived in parentheses on the dotted line next to line 54. Subtract this amount from the total shortfall you figured without regard to the waiver, and enter the result on line 54."

In other words, if you want a waiver of the penalty, you must ignore the instructions on Form 5329 itself, and enter "zero" on line 54, regardless of the fact you know you missed the RMD. Then file the form along with your explanation of reasonable cause and how you remedied the shortfall and you have a chance at getting an IRS waiver.

Form 1099-R: Where's my QCD? Unlike Form 5498, which the IRA provider must file every year for every IRA, Form 1099-R is filed by the IRA provider only when there has been a distribution from the account in the preceding year. If you are over 70 1/2, you are used to getting Form 1099-R early each year, showing the amount distributed to you from your IRA in the year just past.

If you're like many taxpayers, you just collect all those 1099s, hand them to your tax preparer, and go on vacation until she calls to tell you your income tax return is ready to sign. That modus operandi could be costly if you made any charitable contributions in the form of a qualified charitable distribution from your IRA.

QCDs, which have been allowed since 2006, enable over-age-70 1/2 IRA owners to transfer up to $100,000 per year from their IRAs to a qualifying charity. The transfer is not includible in the IRA owner's gross income, even though it does count toward the IRA owner's required minimum distribution for the year.

Suppose Susie's IRA RMD for 2017 was $56,283. Susie has no after-tax money in any IRA. She satisfied her RMD by having a $12,000 QCD sent to her favorite charity and took the remaining $44,283 in cash. Her gross income from these moves is $44,283, because the $12,000 QCD is excludible from her income. Susie might assume that the IRA provider would report to the IRS only the taxable $44,283 that was paid to her and that the $12,000 QCD would be reported, if at all, as a nontaxable distribution.

This assumption would be wrong. In fact the Form 1099-R Susie gets will show a total 2017 IRA distribution of $56,283, with no mention whatsoever that any of it went to a charity, or that there even was a QCD at all. The instructions for IRS Form 1099-R tell the IRA provider that "There is no special reporting for qualified charitable distributions ..." and to report in Box 1 the gross distribution.

It's up to Susie and her tax preparer to remember that part of the distribution was paid to a charity as a QCD. Susie reports the gross distribution (from Box 1 of Form 1099-R) on line 15a (IRA distributions) of her income tax return (Form 1040), and $44,283 on line 15b as the taxable amount. She is supposed to write in "QCD" next to line 15b.

Where to read more: See Instructions for IRS Forms 1040 (2017), line 15, "Exception 3," pp.25-26; 1099-R & 5498 (2017), pp. 1, 9, 18, 19; and 5329 (2017), p. 8.

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie's book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.