TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION
Individual Retirement Account Contributions and Distributions Are Not Adequately Monitored to Ensure Tax Compliance
March 28, 2008
Reference Number: 2008-40-087
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
Phone Number |
202-622-6500
Email Address | inquiries@tigta.treas.gov
Web Site |
http://www.tigta.gov
March 28, 2008
MEMORANDUM FOR COMMISSIONER, WAGE AND INVESTMENT DIVISION
FROM: Michael R. Phillips /s/ Michael R. Phillips
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Individual Retirement Account Contributions and Distributions Are Not Adequately Monitored to Ensure Tax Compliance (Audit #200740010)
This report presents the results of our review to determine whether
the Wage and Investment Division is adequately planning for and addressing tax issues
related to Individual Retirement Accounts (IRA).[1] This review is part of the Treasury Inspector General for Tax
Administration’s Fiscal Year 2007 Annual Audit Plan coverage under the major
management challenge of Complexity of the Tax Law.
Impact on the Taxpayer
As the number of taxpayers reaching retirement age increases,
their incomes will be transitioning from wages to investment and retirement
benefits. IRAs are a key, tax-preferred
way for individuals to save for retirement and are increasingly important as a
way for individuals to roll over savings from pension plans. In 2005, estimated Roth IRA assets totaled
$147 billion, and traditional IRA assets totaled $3.26 trillion. We found that taxpayers are sometimes contributing
more than is allowed into tax-deferred or tax-free accounts and they are not taking
taxable distributions when required, which could result in lost tax revenues. In addition, taxpayers could be treated
inequitably due to the lack of monitoring of IRAs.
Synopsis
The Internal Revenue Service (IRS) needs to strengthen its procedures and controls for ensuring that taxpayers and IRA custodians comply with IRA rules. Failure to ensure correct reporting by IRA custodians could hinder the IRS’ ability to identify excess contributions. Moreover, lack of adequate monitoring and enforcement could result in lost tax revenues when taxpayers make excess contributions or fail to pay excise taxes on required minimum distributions that are not taken.
There are two main types of IRAs, a traditional
IRA and a Roth IRA. Both types allow
taxpayers to contribute up to $4,000 per year ($4,500 if age 50 or older),[2] and provide tax deferral of contributions or
earnings. Traditional IRAs, within
certain income limits and other eligibility factors,[3] allow taxpayers to deduct the amount of
their IRA contributions from their taxable income, thus adding to their tax
deferral benefits. However, taxpayers
must begin to withdraw funds from their traditional IRAs when they reach 70½,
and the funds received are generally taxed as regular income.
Roth IRAs do not provide for a tax deduction for contributions, but the entire amount of the account is tax free when withdrawn. In addition, there is no age limit as to when withdrawals must take place, so taxpayers can accumulate investment earnings tax free for as long as they choose.
We analyzed more than 13.7 million IRA Contribution Information (Form 5498) showing IRA contributions in Tax Year (TY) 2005 and identified 51,109 taxpayers who had made IRA contributions in excess of the maximum allowable IRA contribution limit. Contributions that are in excess of the limits and not properly withdrawn are subject to a 6 percent excise tax. The 51,109 taxpayers we identified made excess contributions of more than $110 million and did not report excise taxes on these excess contributions. The loss to the IRS on unpaid excise taxes was more than $6.6 million in TY 2005. If taxpayers continue to make excess contributions at the same rate we identified, we estimate the amount of excise tax that would not be collected over 5 years would be approximately $33 million.
In addition, because the earnings on the excess contributions are not taxed, the potential loss of taxes paid on interest income could be significant. If these taxpayers continued to make excess contributions to their IRAs, the compounded interest earned over 5 years could total approximately $127 million, and the potential revenue loss from unreported interest income could be more than $19 million.
We also found that the IRS does not ensure that taxpayers are complying with the required minimum distributions rules for IRAs. We matched a file of taxpayers required to take minimum distributions in TY 2005 against a file of TY 2005 distributions and identified 471,383 taxpayers who did not report any distributions. We reviewed a judgmental sample of 30 taxpayer accounts and determined that 5 (17 percent) did not take any or all of their required minimum distributions. The required distributions not taken by the 5 taxpayers totaled $188,852. The 50 percent excise tax that was not reported on this income totaled $94,426. Our limited sample was not intended to provide an overall estimate of revenue loss. However, for perspective, if there are a similar proportion of taxpayers who did not take all of their TY 2005 required distributions, the potential revenue loss from unreported excise taxes could total as much as $1.5 billion for 1 year.
Finally, financial custodians of IRA accounts are making a significant number of errors when preparing and submitting Forms 5498. When analyzing the Forms 5498 for excess contributions, we initially identified more than 107,000 taxpayers who appeared to have made excess contributions. However, as we analyzed a sample of the Forms 5498, we found that more than 52 percent of the Forms 5498 contained obvious errors. We could not determine the cause of the errors without auditing the custodians’ records. However, based on the amounts reported as contributions, it appears that in many instances custodians may have mistakenly included in the “contribution” box the total fair market value of the IRA or the amount rolled over from one IRA to another. We also found multiple Forms 5498 submitted for the same taxpayer that contributed to the appearance of excess contributions.
Recommendations
We recommended that the Commissioner, Wage and Investment Division:
Response
The IRS agreed with all four of our recommendations. Specifically, the IRS plans to gather data through its National Research Program study of TY 2007 individual returns. The study will address issues for all four recommendations, including the following items:
Once the research data becomes available ****(b)(7)(E)****, the IRS will determine the best approach for improving taxpayer reporting behavior, identify cost-effective methods to address taxpayer accounts that are not compliant with Roth IRA contribution rules (such as soft notices), and determine what actions, if any, to take related to Box 11 Form 5498 data.
IRS management did not agree with the projected outcomes associated with the recommendation to develop and implement strategies to bring noncompliant taxpayers back into compliance because management does not believe the outcome measures will be realized if the IRS chooses to take a different route based on the results of its study. Management’s complete response to the draft report is included as Appendix VII.
Office of Audit Comment
We are pleased that the IRS is in full-agreement with our recommendations
and plans to incorporate its corrective action in unison with its planned
action resulting from the recent report issued by the Government Accountability
Office.[4] However, we are
concerned with the IRS’ stated disagreement with the proposed outcome measures
reflected in our report. These measures
were projected over a 5-year period to show the significance of the potential
revenue loss that may occur beyond the actual loss determined from a 100
percent computer analysis of 51,109 taxpayers in TY 2005. Our review of the TY 2005 data clearly
indicates a combined revenue loss of $13.3 million and represents the base year
figure used to project the combined 5‑year outcome measurements of $52
million.
****(b)(7)(E)**** we advised them that the detailed data used to compile the 100 percent computer analysis could be made available to the IRS to enable it to analyze the 51,109 taxpayer accounts identified in TY 2005 and determine the level of subsequent year noncompliance by these taxpayers. This could be used to compliment the IRS’ planned compliance study.
The Treasury Inspector General for Tax Administration has designated this audit report as Sensitive But Unclassified pursuant to Chapter III, Section 23 of the Treasury Security Manual (TD P 71-15) entitled, “Sensitive But Unclassified Information.” Because this document has been designated Sensitive But Unclassified, it may be made available only to those officials who have a need to know the information contained within this report in the performance of their official duties. This report must be safeguarded and protected from unauthorized disclosure; therefore, all requests for disclosure of this report must be referred to the Disclosure Branch within the Treasury Inspector General for Tax Administration Office of Chief Counsel.
Copies of this report are also being sent to
the IRS managers affected by the report recommendations. Please contact me at (202) 622-6510 if you
have questions or Michael E. McKenney, Assistant Inspector General
for Audit (Wage and Investment Income Programs), at (202) 622-5916.
Some Financial Custodians
Are Making Errors When Reporting IRA Contributions
Some Taxpayers Made
Contributions in Excess of the Maximum Allowable Limits
Taxpayers Are Not
Taking Required Minimum Distributions
Appendices
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix
IV – Outcome Measures
Appendix V –
IRA Contribution Information (Form 5498)
Appendix
VII – Management’s Response to the Draft Report
Abbreviations
|
AUR |
Automated Underreporter |
|
IRA |
Individual Retirement Account (also known as
Individual Retirement Arrangement) |
|
IRS |
Internal Revenue Service |
|
TY |
Tax Year |
The
Retirement
assets reached a record high of $14.5 trillion in 2005 and more than 25 percent
of these assets were in IRAs.
More of these taxpayers over age 65 will be transitioning
from wages to pension benefits. In
addition to relying on Social Security and savings to prepare for retirement, a
variety of tax‑advantaged investments can be used that are specifically earmarked
for retirement savings. These include Individual
Retirement Accounts (IRAs),[6] employer-sponsored defined contribution and
defined benefit pension plans, and annuities.
Retirement assets reached a record high of
$14.5 trillion in 2005, an increase of 7 percent over 2004. These savings vehicles are integral to
overall retirement planning and preparedness and account for more than one-third of all household
financial assets. More than 25 percent
of all retirement assets were in IRAs.
IRAs are a key tax-preferred way for individuals to save for retirement and are increasingly important as a way for individuals to roll over savings from pension plans. The funds put into an IRA are tax-deferred, so the account can grow faster than a typical investment account. To illustrate, if a person were to contribute $4,000 a year to an IRA with an 8 percent rate of return for 30 years, the IRA would be worth $449,133 at the end of year 30. If the same funds were invested in a non tax-deferred account, assuming a 31 percent tax rate, it would be worth $286,752 instead of $449,133. That is 36 percent less, a difference of $162,381 (as shown in Figure 1).
Figure 1: Effects of Tax Deferred Growth on an Investment
Figure
1 was removed due to its size. To see
Figure 1, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
There are two main types of IRAs, a
traditional IRA and a Roth IRA. Both
types allow taxpayers to contribute up to $4,000 per year ($4,500 if age 50 or
older) and provide tax-preferred ways of saving for retirement. However, there are some important differences
between the types of IRAs.[7]
The traditional IRA, within certain income
limits and other eligibility factors,[8] allows taxpayers to deduct the amount of
their IRA contributions from their taxable income, thus adding to their tax
deferral benefits. However, taxpayers
must begin to withdraw funds from their traditional IRAs when they reach 70½,
and the funds received are generally taxed as regular income. Also, once taxpayers reach 70½, they can no
longer contribute to their traditional IRA.
Roth IRAs, also subject to certain income
limits, do not provide for a tax deduction for contributions, but the entire
amount of the account is tax free when withdrawn. In addition, there is no age limit as to when
withdrawals must take place, so taxpayers can accumulate investment earnings tax
free for as long as they choose.
While these IRA provisions provide meaningful
benefits to taxpayers, these same provisions can pose a significant risk for
tax revenue loss to the Federal Government if the information provided by IRA
account custodians is not effectively used to prevent potential taxpayer abuse
and/or fraud.
For example, if a 50-year-old taxpayer fully
funded one Roth IRA and then improperly established a second Roth IRA with a
financial custodian different from the custodian of his or her one allowable
account, the potential amount of unreported interest earned and tax-free flow‑through
to beneficiaries could be substantial over 30 years due to the annual
compounding of interest earned, as shown in Figure 2.
Figure 2: Potential
Impact to Internal Revenue Service Revenues
|
Individual With One Unallowable |
$4,500/Yr @ 7% for 10 Years |
$4,500/Yr @ 7% for 20 Years |
$4,500/Yr @ 7% for 30 Years |
Tax Free Proceeds to
Beneficiaries |
|
Principal plus Interest |
$62,174 |
$184,480 |
$425,074 |
$425,074 |
|
(less) Total Contributions |
-$45,000 |
-$90,000 |
-$135,000 |
|
|
Total Unreported
Interest |
$17,174 |
$94,480 |
$290,074 |
|
Source: Treasury Inspector General for Tax Administration Analysis Using a Future Value of an Annuity Calculator.
Additionally, if a taxpayer had sufficient funds to establish more than one unallowable Roth IRA account at various financial institutions, the risk of significant unreported income could be substantially more than the amounts shown in Figure 2. To protect against this risk, IRA custodians are required to report IRA contributions to the Internal Revenue Service (IRS) on IRA Contribution Information (Form 5498) and provide copies to the IRA owners (taxpayers). A separate Form 5498 should be filed for each IRA account. An example of Form 5498 is shown in Appendix V.
Custodians are required to report distributions from IRA accounts on Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. (Form 1099-R). Custodians must also provide the appropriate distribution codes. For example, code 7 for normal distribution, code 4 for death, etc. An example of Form 1099-R is shown in Appendix VI.
Custodians submit Forms 5498 and 1099-R to the IRS’ Information Returns Branch.[9] This branch collects and processes the information returns so they can be used by other IRS functions or programs. Once the information returns are processed, they are posted to the IRS Information Returns Master File.[10] Data on this system may not be available for months, because some information returns are not due until the middle of the following year. For example, Tax Year (TY) 2005 Forms 5498 were not due until May 31, 2006.
The Automated Underreporter (AUR) program is one IRS program that uses the information return data. The AUR is an automated system that helps the IRS identify under-reported and/or over‑reported issues by matching data on information returns to individual income tax returns.[11] ****(b)(7)(E)****
This review was performed at the IRS Campus[12]
in
IRS processing
procedures for IRAs do not ensure that taxpayers and custodians are complying
with the IRA rules. The IRS’ procedures
are not adequate for it to identify taxpayers who make IRA contributions in
excess of what the law allows or taxpayers who are not taking their required
minimum distributions. In addition, IRS
processes do not identify custodians who incorrectly report IRA transactions.
Some Financial Custodians Are Making Errors When Reporting IRA Contributions
More than
52 percent of the taxpayer accounts that appeared to exceed the contribution
limits were caused by custodial errors.
Financial custodians of IRA accounts annually report the amount of contributions to the IRS on Forms 5498. We performed computer analyses on more than 13.7 million Forms 5498 showing IRA contributions in TY 2005 and identified 107,129 taxpayer[14] accounts that appeared to have exceeded the $4,500 maximum allowable IRA contribution limit for TY 2005 and did not report excise taxes on these excess contributions.[15] We analyzed these forms and identified obvious errors totaling nearly $1.3 billion that were reported to the IRS from various financial custodians. Some examples of these custodial errors included:
· A total of $440.1 million of traditional IRA contributions attributable to 489 Forms 5498 (an average contribution of $900,000).
****(b)(3); 26 U.S.C. 6103****
We could not determine the cause of these errors without auditing the custodians’ records. However, based on the amounts reported as contributions, it could be that custodians mistakenly included in the “contribution” box the total fair market value of the IRA or the amount rolled into the IRA from other IRAs or pensions. The errors could also have been caused by misplaced decimal points or other typographical errors. We found that 100 financial custodians accounted for about 77 percent ($996 million of the $1.3 billion) of the total inaccuracies.
Multiple Forms 5498[16] also contributed to the errors identified on Forms 5498. IRS personnel explained that when more than two Forms 5498 are submitted to the IRS, the Information Reporting Program Data Assimilation Unit[17] does not attempt to determine which is the accurate document (the last return submission should reflect the taxpayer’s last action). The file date on the Information Return Master File is the date the information return was entered and not the date the custodian filed the information return or the date it was received by the IRS.
When multiple Forms 5498 are submitted for the same taxpayer and same IRA account, it cannot always be determined which Form 5498 was submitted last. Generally, when there are multiple amendments or corrected documents, the Information Reporting Program Data Assimilation Unit uses the original document in the matching process. The additional documents are appended to the file in the Information Returns Master File, which allows tax examiners to review all of the related taxpayer documents. ****(b)(7)(E)****
To effectively determine whether taxpayers are making excess contributions to their traditional and Roth IRA accounts, the IRS first would need to implement procedures to identify and ensure that Forms 5498 containing obvious errors from financial custodians are corrected and to develop methods to ensure the accuracy and validity of any multiple Forms 5498 that might also be submitted by the custodians. Failure to ensure correct reporting by IRA custodians could hinder the IRS’ ability to identify excess contributions.
Recommendation
Recommendation 1: The Commissioner, Wage and Investment Division, should have the Wage and Investment Research and Analysis office analyze Forms 5498 to identify the causes of the errors and possible corrective actions. The possible corrective actions could include:
· Notifying the custodians of errors identified and requesting corrected Forms 5498.
· Establishing validity checks to reject, or redirect for further analysis, Forms 5498 that are submitted with more than the maximum allowable contribution for that tax year.
· Assessing appropriate penalties against custodians who repeatedly submit erroneous Forms 5498.
Management’s
Response: The IRS agreed with
this recommendation and has already begun corrective action. Specifically, the IRS plans to gather data
through its National Research Program study of TY 2007 individual returns. This data will focus on noncompliance with
traditional and Roth IRA contributions rules and identify potential penalty
amounts for key IRA rules, as well as for taxpayers over age 70½ who do not
take required minimum distributions for traditional IRAs. The IRS will also analyze Forms 5498 in an
effort to identify erroneous filings and develop outreach opportunities
designed to improve taxpayer reporting accuracy. Once the research data becomes available
****(b)(7)(E)**** the IRS will determine the best approach for improving taxpayer
reporting behavior.
Some Taxpayers Made Contributions in Excess of the Maximum Allowable Limits
For TY 2005, IRA
contribution limits were generally the smaller of $4,000 ($4,500 if age 50 or
older by the end of 2005) or taxable compensation. Taxpayers could contribute to both
traditional and Roth IRAs for the same year; however, the total contributions
could not exceed the allowable limit.
For example, a taxpayer 50 or over could contribute $3,000 to a Roth IRA
and $1,500 to a traditional IRA or any other combination provided that the
total contribution did not exceed $4,500.
Contributions that are in excess of the limits and not properly
withdrawn are subject to a 6 percent excise tax.
After eliminating the Forms 5498 that appeared to be in error, we performed an analysis of the remaining 51,109 taxpayer accounts with likely excess contributions.[18] Some examples of these excess contributions include:
****(b)(3); 26 U.S.C. 6103****
Of the 51,109 taxpayer accounts remaining, we were able to
identify $110.1 million in excess contributions[19]
above the allowable $4,500 limit for each of these taxpayers. The $110.1 million amount equates to an IRS
revenue loss of more than $6.6 million in unreported excise taxes. Figure
3 illustrates this loss of revenue and estimates the amount of excise taxes
that would not be collected over 5 years would be approximately $33 million. This estimate is based on the probability that
these taxpayers will continue to make the same excess contributions over the
next 5 years.
Figure 3: Potential Revenue Loss From Unreported Excise
Taxes
|
Taxpayers With Unallowable |
51,109 |
|
Total Contributions in |
$340,133,373 |
|
Less 1 Allowable $4,500
Contribution |
-$229,990,500 |
|
Total Excess Contributions
for |
$110,142,873 |
|
Total Unreported Excise
Taxes |
$6,608,572 |
|
Potential Unreported Excise Taxes Over 5 Years |
$33,042,860 |
Source: Treasury Inspector General for Tax Administration Analysis of TY 2005 Forms 5498.
Taxpayers who exceed the contribution limits have an unfair advantage over compliant taxpayers in that they can earn tax-free interest on excess contributions to Roth IRA accounts. Traditional IRAs are subject to the required minimum distribution rules so that excess contributions, and earnings thereon, would eventually have to be distributed and included in taxable income. However, Roth IRAs are not subject to the required minimum distribution rules.[20] Excess Roth contributions, and the earnings thereon, could continue to grow tax free.
****(b)(7)(E)**** In addition to the $6.6 million loss in excise taxes for TY 2005, Figure 4 shows the potential future compound interest effect from the $110.1 million as it relates to revenue loss from unreported interest over the next 30 years using a 7 percent interest rate and 15 percent tax rate. A single occurrence in TY 2005 would equate to a cumulative $109.2 million revenue loss. However, assuming a repetitive occurrence each year with an equal or larger amount of excess contributions could raise the potential loss to more than $1.1 billion in 30 years due to the compounding interest factor.
Figure 4: Potential Revenue Loss From Unreported Interest
|
|
Interest @ 7% |
Interest @ 7% |
Interest @ 7% |
|
Unreported Interest if
Compounded Only on the Excess Contributions of $110.1 Million From |
$44,338,204 |
$106,524,829 |
$728,292,767 |
|
Revenue Loss @ 15% Effective Tax Rate |
$6,650,731 |
$15,978,724 |
$109,243,915 |
|
|
|
|
|
|
Unreported Interest if
Compounded on Excess Contributions Repeatedly Made in Each Tax Year From 2005
to 2034 |
$127,026,756 |
$526,879,372 |
$7,828,188,969 |
|
Revenue Loss @ 15% Effective Tax Rate |
$19,054,013 |
$79,031,906 |
$1,174,228,345 |
Source: Treasury Inspector General for Tax Administration Analysis Using Future Value of Annuities Formulas.
The Government Accountability Office recently reviewed this area[21] and cited a high degree of noncompliance with Roth IRA contribution rules. It reported that the enforcement gap for Roth IRA contributions rules results in penalty dollars forgone in the near term and exposes the Federal Government to potentially sizeable permanent future losses, because earnings on Roth IRA contributions are generally tax-free.
In
2005, Roth IRA assets totaled an estimated $147 billion. Because of the ramifications of abuse in this
area and the importance of ensuring that the tax law is applied fairly, the IRS
should ensure that taxpayers comply with the tax rules for IRA
contributions. Lack of proper oversight
and administration of these rules could result in potential abuses and risk of revenue loss in the billions of
dollars in future years.
Recommendation
Recommendation 2: The Commissioner, Wage and Investment Division, should develop and implement strategies to bring noncompliant taxpayers back into compliance. These strategies could include:
· Revising the AUR program ****(b)(7)(E)**** so that excess contributions made by taxpayers ****(b)(7)(E)**** the 6 percent excise tax on the total amount of excess contributions could be assessed.
· ****(b)(7)(E)****create special extracts of Form 5498 data from the Information Returns Master File and send notices to taxpayers who appear to have made excess contributions to their IRAs, explaining that the taxpayers need to withdraw any excess contributions or pay the required excise taxes.
· ****(b)(7)(E)****
Management’s Response: The IRS agreed with this recommendation and has already begun corrective action. Specifically, the IRS plans to conduct a study to determine the volume of excess contributions and identify trends related to noncompliant Roth IRA contributions. The IRS will expand the analysis to include traditional IRA contributions information. Once the study is completed and excess contribution amounts are stratified, the IRS will identify cost-effective methods to address taxpayer accounts that are not compliant with Roth IRA contribution rules. One possible outcome may be a soft notice initiative, where every taxpayer meeting certain criteria is sent a notice.
IRS management did not agree with the projected outcomes associated with the recommendation to develop and implement strategies to bring non-compliant taxpayers back into compliance, because management does not believe that the outcome measures will be realized if the IRS chooses to take a different route based on the results of its study.
Office of Audit Comment: We are concerned with the IRS’ stated disagreement with the proposed outcome measures associated with this recommendation. These measures were projected over a 5-year period to show the significance of the potential revenue loss that might occur beyond the actual loss determined from a 100 percent computer analysis of 51,109 taxpayers in TY 2005. Our review of the TY 2005 data clearly indicates a combined revenue loss of $13.3 million and represents the base year figure used to project the combined 5-year outcome measurements of $52 million.
****(b)(7)(E)**** we advised them that the detailed data used to compile the 100 percent computer analysis could be made available to the IRS to enable it to analyze the 51,109 taxpayer accounts identified in TY 2005 and determine the level of subsequent year noncompliance by these taxpayers. This could be used to compliment the IRS’ planned compliance study.
Taxpayers Are Not Taking Required Minimum Distributions
We performed computer analyses on 7.2 million TY 2004 Forms 5498 of taxpayers who were required to take minimum distributions in TY 2005 and identified 471,383 taxpayers (more than 6 percent) who did not report any distributions. We reviewed a judgmental sample of 30 taxpayer accounts and determined that 5 taxpayers (17 percent) did not take any or all of their TY 2005 required minimum distributions. We determined that $188,852 (72 percent) of $261,447 total estimated required minimum distributions for the 5 taxpayers were not taken. The 50 percent excise tax that was not reported on this income totaled $94,426. Our limited sample was not intended to provide an overall estimate of revenue loss. However, for perspective, if there are a similar proportion of taxpayers who did not take all of their TY 2005 required distributions, the potential revenue loss from unreported excise taxes could total as much as $1.5 billion for 1 year.[22]
We could not determine for 4 deceased taxpayers (13 percent) whether the beneficiaries took the required minimum distribution. The IRS does not have access to beneficiary information and cannot verify that required minimum distributions of deceased taxpayers are taken by the beneficiaries.[23]
We also found obvious errors with custodians’ reporting of the required minimum distributions. Some examples include:
When a taxpayer
reaches age 70½, yearly minimum distributions from traditional IRA accounts are
required. Roth IRA accounts are not
subject to the required minimum distribution rules. IRA custodians are required to identify on
Form 5498 if a taxpayer is required to take a minimum distribution for the next
year, but the amount of the distribution is not reported. Individual
Retirement Arrangements (IRAs) (Publication 590) contains life expectancy
tables to assist taxpayers in calculating their minimum required distributions
for the year. Any portion of the
required minimum distribution not taken by a taxpayer by the end of the year may
be subject to a 50 percent excise tax which is reported on line 60 of the
individual income tax return.[24]
Taxpayers are
required to report taxable traditional IRA distributions on line 15 of their
individual income tax return. The
taxpayer’s copies of Forms 5498 and 1099-R are not required to be attached to
the tax return unless Federal income tax is withheld and reported on 1099-R. Custodians are given two alternatives for
reporting to the taxpayer that a minimum distribution is required. They can compute the amount of the required
minimum distribution and provide this amount to the taxpayer, or they can
inform the taxpayer that a minimum distribution is required and offer to
compute the amount at the taxpayer’s request.
However, the custodian does not report this amount to the IRS.
While our analysis is based on a limited sample of cases, it shows that the IRS does not ensure that taxpayers and custodians are complying with the required minimum distribution rules. When the IRS issued the final regulations for required minimum distributions in 2002, it expressed concerns about the overall level of compliance in this area. The IRS indicated that it intended to monitor the effect of the reporting requirements for minimum distributions on compliance to determine whether it would be appropriate to modify the process in the future.[25] We did not find any evidence of IRS monitoring during our review. In addition, there are no reporting requirements for required minimum distributions with respect to beneficiaries. As a greater percentage of taxpayers reach the age when they are required to start receiving distributions from their IRAs, the potential for compliance problems becomes even larger. In 2005, traditional IRA assets totaled an estimated $3.26 trillion. Noncompliant taxpayers not taking required minimum distributions could result in billions of dollars in uncollected taxes.
Recommendations
The Commissioner, Wage and Investment Division, should:
Recommendation 3: Consider using the
indicator shown on Form 5498,
Management’s Response:
The IRS agreed with this recommendation
and has already begun corrective action.
Specifically, the IRS has requested that
Recommendation 4: Consider requiring custodians to report estimated
required minimum distribution amounts on Form 5498 in the blank box to the left
of
Management’s Response: The IRS agreed with this recommendation and has already begun corrective action. Specifically, the IRS will include this information request in the design of the data collection instrument for the National Research Program study of TY 2007 individual returns. ****(b)(7)(E)****
Appendix I
Detailed Objective, Scope, and Methodology
Initially, we planned to examine several tax issues affecting older taxpayers, but due to resource constraints, we revised our overall objective to determine whether the Wage and Investment Division is adequately planning for and addressing tax issues related to IRAs. The audit focused on the following issues for traditional or Roth IRAs: contributions in excess of the maximum allowable limit of $4,500 for TY 2005; errors reported on IRA Contribution Information (Form 5498); and required minimum distributions from traditional IRAs. To accomplish our objective, we:
I. Identified the number of taxpayers with IRA contributions in excess of the $4,500 maximum limit for TY 2005 and estimated the total excess contributions for the taxpayers.
A. Obtained computer extracts from the Information Returns Master File[27] of traditional and Roth IRA contributions reported by custodians on Form 5498 for TY 2005. Our extract criterion for traditional IRA data was all Forms 5498 with an amount in Box 1 (traditional IRA contribution) and “IRA” checked in Box 7. Our extract criterion for Roth IRA data was all Forms 5498 with an amount in Box 10 (Roth IRA contribution) and “Roth IRA” checked in Box 7. The Treasury Inspector General for Tax Administration Office of Information Technology staff provided the computer extracts.
B. Evaluated the reliability of computer-processed data in both extracts and ensured that the records were accurate by selecting several records and researching them on the Integrated Data Retrieval System.[28]
C. Analyzed the data to identify taxpayers with IRA contributions exceeding the $4,500 maximum limit for TY 2005.
D. Estimated
the sum of the excess IRA contributions for the taxpayers identified in
Step C. above and calculated the 6 percent excise tax on the combined excess
contributions.
II. Identified the number of TY 2005 Forms 5498 with apparent incorrect IRA contributions.
A. Analyzed the computer data extracts from Step I.A. to identify IRA contributions of $900,000 or more.
B. Analyzed the computer data extracts from Step I.A. to identify IRA contributions between $10,000 and $899,999.
III. Identified taxpayers who were required to take a minimum distribution for TY 2005 but did not take a distribution during 2005.
A. Obtained
a computer extract from the Information Returns Master File of TY 2004 Forms
5498 with a check in
B. Evaluated the reliability of computer-processed data in both extracts and ensured that the records were accurate by selecting several records and researching them on the Integrated Data Retrieval System
C. Compared the taxpayers in the first extract (TY 2004 Forms 5498) to the taxpayers in the second extract (TY 2005 Forms 1099-R). We identified 471,383 taxpayers who were required to take minimum distributions in 2005 but did not have a 2005 Form 1099‑R indicating a distribution was taken.
D. Reviewed a judgmental sample of 30 of the 471,383 taxpayer accounts to determine why they did not take a minimum distribution in TY 2005. A judgmental sample of 30 taxpayer accounts was considered sufficient to demonstrate the potential effect of inadequate controls over required minimum distributions.
Appendix II
Major Contributors to This Report
Michael
E. McKenney, Assistant Inspector General for Audit (Wage and Investment Income
Programs)
Scott
A. Macfarlane, Director
Gary
L. Young, Audit Manager
Sharon
A. Buford, Lead Auditor
John
L. Hawkins, Senior Auditor
Elizabeth
A. Miller, Senior Auditor
Tina
M. Parmer, Senior Auditor
Lawrence
N. White, Senior Auditor
Bonnie
G. Shanks, Auditor
Judith P. Harrald, Information Technology
Specialist
Appendix III
Commissioner C
Office of the Commissioner – Attn: Acting Chief of Staff C
Deputy Commissioner for Services and Enforcement SE
Deputy Commissioner, Wage and Investment Division SE:W
Director, Compliance, Wage and Investment Division SE:W:CP
Director, Customer Account Services, Wage and Investment Division SE:W:CAS
Director, Strategy and Finance, Wage and Investment Division SE:W:S
Director, Reporting Compliance, Wage and Investment Division SE:W:CP:RC
Director, Submission Processing, Wage and Investment Division SE:W:CAS:SP
Chief, Performance Improvement, Wage and Investment Division SE:W:S:PI
Chief Counsel CC
National Taxpayer Advocate TA
Director, Office of Legislative Affairs CL:LA
Director, Office of
Program Evaluation and Risk Analysis
RAS:O
Office of Internal
Control OS:CFO:CPIC:IC
Audit Liaison: Senior Operations Advisor, Wage and Investment Division SE:W:S
Appendix IV
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. These benefits will be incorporated into our Semiannual Report to Congress.
Type and Value of Outcome Measure:
· Increased Revenue – Potential; $33,042,860 in excise taxes over 5 years due to 51,109 taxpayers not reporting more than $110,142,873 of excess contributions to IRAs (see page 7).
Methodology Used to Measure the Reported Benefit:
We performed computer analyses on more than 13.7 million IRA Contribution Information (Form 5498) showing IRA contributions in TY 2005 and identified 107,129 taxpayer accounts that appeared to have exceeded the $4,500 maximum allowable IRA contribution limit for TY 2005 and did not report excise taxes on these excess contributions.[29] In an effort to validate our analysis of actual instances of excess contributions, we eliminated as obvious errors all Forms 5498 that showed an IRA contribution greater than the maximum allowable of $4,500.[30] Our results effectively reduced the 107,129 taxpayer accounts that we had initially identified to 51,109.[31]
These 51,109 taxpayers had total contributions in 2005 of $340,133,373. Because these taxpayers should have only been allowed one $4,500 contribution totaling $229,990,500, we identified $110,142,873 in excess contributions[32] above the allowable $4,500 limit for each of these taxpayers. The total unreported 6 percent excise taxes on the $110,142,873 would be $6,608,572 in TY 2005.
We believe that these
taxpayers could continue to make the same excess contributions in subsequent
years and estimated that over 5 years the amount of tentative excise taxes that
would not be collected would be approximately $33,042,860.
Type and Value of Outcome Measure:
· Increased Revenue – Potential; $19,054,013 in tax over 5 years on an estimated cumulative amount of $127,026,756 in unreported interest on excess contributions to IRAs (see page 7).
Methodology Used to Measure the Reported Benefit:
In addition to the $6,608,572 loss in excise taxes for TY 2005, there is a potential future compound interest effect from the $110,142,873 as it relates to revenue loss from unreported interest over the next 5 years. Our calculations were made using future value annuities formulas.
We calculated the compounded unreported interest on the excess contributions of $110,142,873 identified for TY 2005 using an interest rate of 7 percent. We identified an estimated cumulative amount of $127,026,756 in unreported interest if the excess contributions were made repeatedly each year for the next 5 years. We used the assumption that if the taxpayer made an unallowable contribution in TY 2005, this unallowable contribution would be recurring in future years.
In addition, we applied a 15 percent tax rate and determined that $19,054,013 in potential tax could be unreported over the next 5 years on the $127,026,756.
Type and Value of Outcome Measure:
· Increased Revenue – Potential; $94,426 in excise taxes for required minimum distributions that were not taken by 5 taxpayers from their IRAs (see page 11).
Methodology Used to Measure the Reported Benefit:
We performed an analysis of taxpayers who were required to take minimum distributions in TY 2005 and identified 471,383 taxpayers who were required to take minimum distributions, but no distributions were reported. We reviewed a judgmental sample of 30 taxpayer accounts and determined that 5 taxpayers (17 percent) did not take any or all of their 2005 required minimum distributions. We determined that $188,852 (72 percent) of the $261,447 total estimated required minimum distributions for the 5 taxpayers was not taken. The 50 percent excise tax that was not reported on this income totaled $94,426.
Appendix V
IRA Contribution Information (Form 5498)
Figure 1 shows Copy A of a blank Form 5498 for TY 2005. Copy A is filed with the IRS. Not shown are Copy B, which is provided to the IRA owner, and Copy C, which is kept by the IRA custodian who prepared the Form 5498.
Figure 1: Form 5498
Figure 1 was removed due to its size. To see Figure 1, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Traditional IRA – Custodians must report the amount
of contributions to a traditional IRA in
Roth IRA – Custodians must report the amount of contributions to a Roth IRA in Box 10 and may check “Roth IRA” in Box 7.
Required Minimum Distributions – Custodians must check Box 11 if the IRA owner is required to take a minimum distribution for the new tax year. The custodian is not required to report the amount to the IRS.
Appendix VI
Distributions From Pensions, Annuities, Retirement or
Profit-Sharing Plans, IRAs, Insurance Contracts, etc. (Form 1099-R)
Figure 1 shows Copy A of a blank Form 1099-R for TY 2005. Copy A is filed with the IRS. Not shown are Copies 1 and 2, which are provided to be filed with a State, city, or local income tax return; Copies B and C, which are provided to the IRA owner; and Copy D, which is kept by the IRA custodian who prepared the Form 1099-R.
Figure 1: Form 1099-R
Figure 1 was removed due to its size. To see Figure 1, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
Required Minimum Distributions from Traditional IRAs
– Custodians must report a traditional IRA distribution in
Custodians should check the “IRA/SEP/SIMPLE” checkbox and enter the appropriate distribution code in Box 7. A Guide to Distribution Codes is included in the IRS’ TY 2005 Instructions for Forms 1099-R and 5498.
Appendix VII
Management’s Response to the Draft Report
The response was
removed due to its size. To see the
response, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
TD P 15-71
[1] The term IRA is also known as Individual Retirement Arrangement and includes individual retirement annuities. It is popularly known as IRAs.
[2] These were the contribution limits in effect for Tax Year 2005, which is the period we evaluated. The contribution limit for taxpayers 50 and over was raised to $5,000 for Tax Year 2006.
[3] Eligibility takes into account whether the taxpayer has taxable compensation, age at the end of the year, and the income limits and filing status if the taxpayer or spouse had an employer-sponsored retirement account.
[4] Individual Retirement Accounts: IRS Enforces Some but Not All Key Rules, and Opportunities Exist to Strengthen Taxpayer Compliance (GAO-07-1059SU, dated September 2007).
[5]
[6] The term IRA is also known as Individual Retirement Arrangement and includes individual retirement annuities. It is popularly known as IRAs.
[7] These were the contribution limits in effect for Tax Year 2005, which is the period we evaluated. The contribution limit for taxpayers 50 and over was raised to $5,000 for Tax Year 2006.
[8] Eligibility takes into account whether the taxpayer has taxable compensation, age at the end of the year, and the income limits and filing status if the taxpayer or spouse had an employer-sponsored retirement account.
[9] A branch in the IRS Modernization and Information Technology Services function.
[10] The Information Returns Master File contains tax information reported from third parties for the current and prior 5 tax years.
[11] Form
1040 series:
[12] The campuses are the data processing arm of the IRS. They process paper and electronic submissions, correct errors, and forward data to the Computing Centers for analysis and posting to taxpayer accounts.
[13] The IRS database that maintains transactions or records of individual tax accounts.
[14] We originally identified 114,107 taxpayer accounts that appeared to have exceeded the $4,500 maximum allowable limit. However, 6,978 of these taxpayer accounts had multiple Forms 5498, and we could not determine if they were custodial errors. These accounts were eliminated from our total taxpayer accounts reported of 107,129.
[15] To avoid erroneously identifying taxpayers 50 years and older as having exceeded their IRA contribution limit, we used the maximum allowable amount of $4,500 for TY 2005.
[16] The term multiple includes original, corrected original, and amended Forms 5498.
[17] A unit within the IRS Modernization and Information Technology Services function.
[18] We also eliminated 6,644 taxpayer accounts where it appeared that no excess contributions were made.
[19] Contributions greater than the $4,500 maximum allowable contribution limit for TY 2005 are defined as “excess” IRA contributions.
[20] There are some exceptions. For example, the required minimum distribution rules that apply to traditional IRAs apply to beneficiaries of Roth IRAs.
[21] Individual Retirement Accounts: IRS Enforces Some but Not All Key Rules, and Opportunities Exist to Strengthen Taxpayer Compliance (GAO-07-1059SU, dated September 2007).
[22] We calculated this excise tax by averaging the $188,852 estimated required distributions that were not taken by the 5 taxpayers identified in our sample ($37,770) and multiplied it by 17 percent of the 471,383 taxpayers (80,135), which equaled $3,026,698,950 in minimum required distributions that were not taken. The 50 percent excise tax that would be due on this income totals $1,513,349,475.
[23] No reporting of required minimum distributions with respect to beneficiaries is required at this time.
[24] In some instances, taxpayers may be able to waive the penalty due to reasonable cause.
[25] Notice 2002-27, Reporting Required Minimum Distributions From IRAs, I.R.B. 2002-18 (May 6, 2002); T.D. 8987 and REG-108697-02 in I.R.B. 2002-19 (May 13, 2002).
[26] The period from January through mid-April when most individual income tax returns are filed.
[27] The Information Returns Master File contains tax information reported from third parties for the current and prior 5 tax years.
[28] The IRS computer system capable of retrieving or updating stored information, which works in conjunction with a taxpayer’s account records.
[29] To avoid erroneously identifying taxpayers 50 years and older as having exceeded their IRA contribution limit, we used the maximum allowable amount of $4,500 for TY 2005.
[30] We considered these contributions as obvious errors, given that financial custodians would be aware of the contribution limitations and amounts reported more than $4,500 would in all probability be errors.
[31] We also eliminated 6,644 taxpayer accounts where it appeared that no excess contributions were made.
[32] Contributions greater than the $4,500 maximum allowable contribution limit for TY 2005 are defined as “excess” IRA contributions.