The Worst Tax Penalties and How to Help Your Clients Avoid Them
 

The Worst Tax Penalties and How to Help Your Clients Avoid Them

A question I continually hear from my clients is, “How do I pay less tax?” But as you know, there is no simple answer to this question. While tax reduction strategies do exist, they are limited for the majority of taxpayers−and they do take some planning and attention. But there is one tax saving approach we can always assist our clients with, and that is educating them about tax penalties. What follows is a list of the most punitive tax penalties along with simple tips on making sure your clients are never faced with them.

Failure to Make Retired Minimum Distributions 

Do you have any retired clients who are 70 ½ or older, or who turned 70 ½ this year? A quick and easy way to help them save on taxes is to make sure they take their Required Minimum Distributions (RMDs). Failure to do so can result in one of the most punitive tax penalties of all–50% of the required amount not withdrawn. Remember, the rule does not apply for those who own less than 5% of a company that they are still working at.

You can help your clients avoid this penalty by checking in with them now to remind them about taking their RMDs. There are numerous RMD calculators available online that will help you determine the correct amount. You will need your client’s previous year-end account balance for all the IRAs and pension plans subject to the RMD and their age at year end. A special rule extends the deadline to April 1st for those who turn 70 ½ during the year.

If you do happen to have a client who ends up with an RMD penalty you may be able to help them get it waived if you can show "reasonable error" and "reasonable" steps they are taking to correct it.

Premature Retirement Plan Distributions

One of the most deceiving penalties of all is the penalty for premature retirement plan distributions. While a client who needs immediate cash may not be deterred when you tell them about this 10% additional tax, it's important that they understand the full impact it may have on their financial situation. This penalty hurts your clients not only in the year it applies. The transaction that caused the penalty–the early distribution itself–may carry ramifications that extend into your client's retirement because the money is no longer in their account and growing.

Many taxpayers who take distributions don’t realize that this 10% penalty is in addition to their regular tax rate, and that the additional taxable income could push them into a higher tax bracket. It could also trigger the Net Investment Income Tax of 3.8 % and the Additional Medicare Tax of 0.9%.

You can help your clients avoid this penalty by checking in with them now to remind them about taking their RMDs. There are numerous RMD calculators available online that will help you determine the correct amount. You will need your client’s previous year-end account balance for all the IRAs and pension plans subject to the RMD and their age at year end. A special rule extends the deadline to April 1st for those who turn 70 ½ during the year.

If you do happen to have a client who ends up with an RMD penalty you may be able to help them get it waived if you can show "reasonable error" and "reasonable" steps they are taking to correct it.

While there are numerous exceptions to the penalty–for college, medical, insurance, and home purchase expenses−a careful reading is required to determine eligibility. For example, one of the trickiest is the exception for medical expenses. The penalty is waived only on the amount of deductible medical expenses, which is the amount that exceeds either 7.5% or 10% of your client’s AGI, depending on their age.

In addition, I’ve seen many taxpayers take funds from their 401(k)s under the belief that there is an exception for a first time home purchase. But this exception is only for Individual Retirement Arrangements (also known as Individual Retirement Accounts). Read more on CPA Practice Advisor.