Individual Retirement Accounts: Additional IRS Actions Could Help Taxpayers Facing Challenges in Complying with Key Tax Rules
Published: 2008-08-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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

section_title: Letter
paragraphs: Created over 30 years ago, individual retirement accounts—popularly  known as IRAs—are a key tax-preferred vehicle for individuals to save for  retirement. According to the Internal Revenue Service’s (IRS) latest  analysis, about 51 million taxpayers held $3.3 trillion in IRAs at year-end  2004. 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.
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. This reflects the revenue losses by the federal  government due to the preferential tax treatment of both traditional and  Roth IRAs. 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. 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. 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. There are also two kinds of employer-based  IRAs—Savings Incentive Match Plans for Employees (SIMPLE) and  Simplified Employee Pensions (SEP). 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. 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. 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. 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. 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. 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.
subsections: section_title: Background
paragraphs: 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. 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.
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.
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.
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.
section_title: Myriad of Rules Govern IRA Transactions, and IRS Provides Services to Educate Taxpayers
paragraphs: 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. 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.
subsections: section_title: Contribution Rules
paragraphs: 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. 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) 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.
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.
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.
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. 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.
section_title: Distribution Rules
paragraphs: 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. In contrast, Roth IRA distributions  are tax-free after age 59½ as long as the taxpayer has held the Roth IRA for  5 years. For both traditional and Roth IRAs, early distributions before age  59½ for reasons other than specific exceptions result in 10 percent  additional tax.
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. 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.
section_title: Rollover and Conversion Rules
paragraphs: 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. 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. 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. 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.
section_title: IRS Reporting Rules for Taxpayers and IRA Custodians
paragraphs: 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. 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. 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. 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.
section_title: IRS’s Service Activities Aim to Increase Taxpayer Understanding of IRA Rules
paragraphs: 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.
section_title: IRS Research and Enforcement Data Show Taxpayers Misreport Millions of Dollars in Traditional IRA Transactions
paragraphs: 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. 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.
subsections: section_title: Research Shows Taxpayers Misreport Millions in Traditional IRA Transactions
paragraphs: 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 misreporte95   taxes when taking withdrawals. NRP results for 2001 yield a measure of  noncompliance across taxpayers.
Of taxpayers who made deductible traditional IRA contributions, an  estimated 14.8 percent (554,657 taxpayers) 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). The understated  net income due to these misreported traditional IRA contribution  deductions was $392 million, 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 (1.5 million taxpayers) 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). The underreported net income due to  misreported IRA distributions was $6.3 billion, 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.
section_title: Automated Enforcement Detects and Corrects Millions in IRA Noncompliance
paragraphs: 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. 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.
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. 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. 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.
subsections: section_title: Automated Underreporter Program
paragraphs: 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. 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.
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. 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.
section_title: Correspondence Examinations
paragraphs: 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.
section_title: Field Examinations
paragraphs: 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.
section_title: 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
paragraphs: 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. Some options to reduce IRA rule  complexity would require changing the laws governing IRA contributions  and distributions.
subsections: section_title: Challenges with IRA Contribution Rules
paragraphs: 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. 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. 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.” 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. 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.
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.
section_title: Challenges with IRA Distribution Rules
paragraphs: 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.
section_title: Challenges with IRA Rollover Rules
paragraphs: 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.
section_title: Options Include Enhanced IRS Service to Help Taxpayers Better Understand IRA Rules and Regulatory or Legislative Changes to Simplify Some IRA Rules
paragraphs: 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.
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.
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. 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.
section_title: Conclusions
paragraphs: 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.
section_title: Recommendations for Executive Action
paragraphs: 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.
section_title: Agency Comments
paragraphs: 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  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.
section_title: Appendix I: Scope and Methodology
paragraphs: 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.  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.
subsections: section_title: Objective 1: Provide an Overview of Key IRA Contribution, Distribution, and Other Rules
paragraphs: 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.
section_title: Objective 2: Describe What IRS Knows about the Extent of Noncompliance for IRA Transactions Reported on Tax Returns
paragraphs: 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. 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. 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.
section_title: Objective 3: Describe Challenges That Taxpayers Face with Key IRA Rules and Options for Strengthening Taxpayer Compliance
paragraphs: 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.
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. 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.
section_title: Appendix II: IRS Forms Used to Report Individual Retirement Account Information
subsections: section_title: Submitted to Copied to
paragraphs: 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).
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.
To report additional tax related to an IRA being paid because of
Early, unexcepted, 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.
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.
To request no withholding or additional withholding on  distributions from a traditional IRA (other than eligible rollover  distributions).
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.
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.
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.
section_title: Appendix III: Comments from the Internal Revenue Service
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: 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.
section_title: Glossary
paragraphs: 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.
subsections: section_title: Basis
paragraphs: The accumulated nondeductible contributions in a traditional IRA.
section_title: Compensation
paragraphs: 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.
section_title: Contribution
paragraphs: An amount, subject to limits, deposited into an IRA.
subsections: section_title: Deductible Contribution
paragraphs: 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.
section_title: Nondeductible Contribution
paragraphs: 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.
section_title: Roth Contribution
paragraphs: 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.
section_title: Excess Contribution
paragraphs: A contribution made in excess of eligible amount for the year, which is  subject to a 6 percent additional tax to penalize excess contributions.
section_title: Conversion
paragraphs: A specific type of rollover in which funds on deposit in a traditional IRA  are transferred to a Roth IRA.
section_title: Distribution
paragraphs: 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.
subsections: section_title: Early Distribution
paragraphs: 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.
section_title: Eligible Rollover Distribution
paragraphs: A distribution made to an account owner that is eligible to be contributed  via rollover to another IRA or qualified plan.
section_title: Required Minimum Distribution
paragraphs: 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.
section_title: Excess Accumulation
paragraphs: 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.
section_title: IRA (Individual Retirement Account)
paragraphs: 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.
subsections: section_title: Roth IRA
paragraphs: An IRA that accepts after-tax contributions subject to limits and allows  tax-free withdrawals.
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.
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.
section_title: Traditional IRA
paragraphs: An IRA that accepts both deductible and nondeductible contributions,  subject to limits, and makes taxable distributions.
section_title: Modified Adjusted Gross Income (AGI)
paragraphs: 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.
section_title: Phaseout Range
paragraphs: The range of modified AGI during which the eligible contribution amount  phases down from the maximum amount to zero.
section_title: Recharacterization
paragraphs: A process by which an ineligible contribution is moved, before the tax- filing deadline, to an account that is eligible to receive it.
section_title: Rollover
paragraphs: The process by which funds on deposit in a qualified employer plan or  another IRA are transferred to an IRA.
subsections: section_title: Direct Rollover
paragraphs: A rollover that is transferred, tax-free, directly from one trustee to another  with no distribution being made to the account owner.
section_title: Trustee
paragraphs: A financial institution that maintains an account owner’s IRA.
section_title: Withholding
paragraphs: The amount held back by a trustee when a distribution is made to an  account owner; amount of withholding depends on type of distribution.