#001 – The Worst Tax Form

Our vote for “worst tax form” is the 1099-R. This is the form taxpayers (and the IRS) receive reporting distributions from:

• Profit-sharing or retirement plans.
• Any individual retirement arrangements (IRAs).
• Annuities, pensions, insurance contracts, survivor income benefit plans.
• Permanent and total disability payments under life insurance contracts.
• Charitable gift annuities, etc.

That’s the technical explanation from the IRS website, but more commonly in practice, how this gets thought about is the 1099-R reports things like:

• Retirement plan distributions (“I need money from my IRA or 401(k)”)
• Pension payments
• Roth conversions (even “in-plan” conversions within a 401(k) will generate a 1099-R since there is technically a distribution involved)
• Back door Roth contributions (technically, this reporting the “conversion” piece already mentioned but is worth reporting separately)
• Qualified charitable distributions (QCDs, definitely the topic of an upcoming newsletter)
• Rollovers between plans
• Requirement minimum distributions
• Distributions of excess contributions
• And the list goes on

Getting the reporting wrong on any of these can lead to penalties, interest, and potentially being taxed twice on the same dollars, so why the disdain? Because the 1099-R does NOT clearly report enough information to ensure that mistakes are avoided. For this newsletter, we will ignore amended 1099s and 1099s that are just plain wrong (which unfortunately does happen) and focus on how even when the form is technically correct, it can still be misleading.

Perhaps the single biggest culprit is Box 2b, “Taxable amount not determined”. We see this box get checked for everything from QCDs to Roth conversions to IRA rollovers. What this box really means is, “the custodian isn’t sure what to tell you…so good luck!”

Box 1 of the 1099-R is the full amount that came out of the account for the year in the aggregate. Only one 1099-R is issued regardless of how many separate distributions occur. So that $5,000 QCD you did separate from the client’s monthly distributions for their lifestyle so it would be easier at tax time didn’t accomplish anything because it all gets lumped together on this form.

In theory, Box 2a should be the amount of Box 1 that is actually subject to tax…in theory. Again, ignoring situations where there is an error, this box is frequently misleading and doesn’t even attempt to tell you how it should be taxed at the state level (there are boxes for state taxes, but proceed with caution).

Then we get to Box 2b, which tells you to essentially not trust Box 2a no matter what it tells. Making matters worse, there is no consistency with how Box 2a is completed when Box 2b is checked. In the same week this year, during filing season, we saw a 1099-R for a Roth conversion where Box 2a was blank and one where Box 2a simply had the full amount from Box 1; both led to confusion that ultimately had to be sorted out by talking with the Advisor.

We saw dozens of potential issues from these two boxes alone this last filing season. Just because the custodian sends out the tax form doesn’t mean your client has the information they need.

What can you do about it?

The single best thing we’ve found is to prepare and send an annual 1099 Letter (existing RTS members can download a copy here) to your clients and their tax preparers. Educating your clients certainly helps but sending the information they need (what each 1099 really represents) when they need (right after the calendar year turns over) in a way that they can easily relay to their preparer (a 1-2 page letter they can literally just forward or hand to their preparer) is what makes the biggest difference.

The other thing every Advisor who helps create a 1099-R (which is all of you) during the year should do is review their client’s tax return to make sure everything got reported correctly. Tax planning doesn’t count until it’s reported correctly to the IRS. This is just one of the reasons we constantly harp on getting tax returns for every client every year.

Happy Tax Planning!