The Internal Revenue Service (IRS) uses algorithms (i.e., computer program applications) to examine the data that it receives and then fires off notices to taxpayers to explain distributions from individual retirement accounts (IRAs) and other forms of retirement accounts. When an individual withdraws money from his or her retirement account, this action is considered a taxable event, and subsequently, a percentage of the amount withdrawn is taxed. As a result, one can understand why the IRS would hope to prove that taxpayers’ withdrawals from their respective retirement accounts are taxable if this was not indicated as such on their tax returns. The IRS is run like a business, focusing its enforcement efforts in areas that will generate large amounts of money—money that was purposely or mistakenly underreported as taxable.
Taxing Retirement Account Withdrawals
Taxpayers may think that the money that they withdraw from their retirement accounts is not taxable, but if they did not follow the rules, then their withdrawn amount may be fully taxable. Many people believe that most retirement account distributions are not taxable when in actuality, they are indeed taxable. If the IRS does not challenge the taxpayer on this, then the taxpayer will walk away without having their retirement account distribution taxed (i.e., a significant portion of taxable income will be accidentally considered tax-free). Some of the reasons why someone might think that his or her retirement account distribution is tax-free when in reality it is taxable include:
- The taxpayer did not actually complete a rollover
- The taxpayer made a prohibited transaction that disqualified the retirement account and did not realize that he or she actually distributed the money
Throughout my career, I have seen these mistakes and more, and fixing these mistakes is almost impossible. It is therefore imperative to avoid making these mistakes in the first place.
The purpose of this article is to showcase that IRS algorithms are continually looking to claim that you owe more in taxes than you actually do—unless you can prove that you managed your retirement account withdraw properly. The IRS most likely expects only less than 10% of their notices to actually find a taxpayer who is not in compliance and who will thus ultimately owe additional tax. Therefore, it is important not to be intimidated by such an IRS notice. Do not give the IRS what they request so that they can close the proposed tax increase, because it is more than likely that you are correct (not the IRS). If you do not feel confident responding to the IRS yourself, then it is wise to seek professional help.
It is understandable why the IRS is motivated to send out their notices to taxpayers, but in reality, approximately 90% of these notices are nothing more than a waste of time for all involved. So far this year, I have spent almost 40 hours attempting to prove that IRS notices that have been sent to my clients are totally unfounded, but the IRS insists on further proof. This has proven to be a waste of both time and resources for not only my clients and me, but also for the IRS.