Assessing the Consequences of the SECURE Act 2.0 RMD Penalty Reductions

The IRS penalty for missing a required minimum distribution for many years was 50 percent of the amount that should have been withdrawn from a traditional IRA or a qualified retirement plan but was not. The IRS penalty, known as an “excess accumulation” penalty, was one of the largest penalties that the IRS imposed.

The 50 percent “excess accumulation” penalty was so severe that the IRS rarely assessed it. In fact, the IRs waived the penalty altogether provided the traditional IRA owner made up the RMD shortfall and filed IRS Form 5329 (Additional Taxes on Qualified Retirement Plans  Including IRAs and Other Tax-Favored Accounts), presenting a reason for initially not taking the correct RMD. Reasons presented on IRS Form 5329 and acceptable by the IRS included: Confusion over the RMD rules; incorrect advice from an adviser or a financial institution; illness or family medical issues; disability or death.

Penalty Relief Provision Under SECURE Act 2.0

SECURE Act 2.0 passed into law in December 2022, contained numerous provisions affecting IRAs and qualified retirement plans. One provision coming out of SECURE Act 2.0 is the reduction of the 50 percent penalty to 25 percent, and to 10 percent if the missed RMD was made up within two years. The penalty reduction has been in effect since January 1, 2023. The IRS has also suggested that a 100 percent penalty waiver is available for a traditional IRA owner, if the steps (discussed above) are taken.

Another provision of SECURE Act 2.0 that Congress addressed and passed into law is with respect to the statute of limitation (SOL) on assessing an RMD penalty. In general, an SOL determines how many years the IRS can go back to enforce a part of the Internal Revenue Code; in this case, an RMD penalty. With a filed individual tax return, the IRS has a three-year SOL. The SOL is six years when an individual tax return understates more than 25 percent of actual gross income. There is no SOL in cases of fraud or a willful attempt to evade federal income taxes.

It is important to note that before the passage of SECURE Act 2.0, there was no SOL for the IRS to assess an RMD penalty. The filing of an individual tax return (Form 1040) did not initiate an SOL period with respect to the RMD penalty. The only way to get an SOL period started was for an individual to file IRS Form 5329 as part of his or her federal income tax income tax return. In that sense, Form 5329 was considered a separate tax return with its own SOL.

In SECURE Act 2.0, Congress attempted to fix this problem of the SOL RMD penalty by allowing the filing of Form 1040 - with or without Form 5329 - to initiate the SOL period. If Form 5329 is filed as part of Form 1040, then the SOL available with Form 5329 remains in place.

The SOL available by the mere filing of Form 1040 without the filing of Form 5329 is a welcome change. However, this provision passed as part of SECURE Act 2.0 (and effective starting with the filing of 2022 individual income tax returns) is not retroactive according to a recent Tax Court case. This means that for pre-2022 individual tax returns filed without Form 5329 (in which the RMD penalty was 50 percent) remain open for the IRS to assess prior year RMD penalties.