Better to ‘Fess Up to a Tax Mistake Regarding Your IRA? Or Can You Just Let It Slide?

Q My only income is from rentals and investments. Four years ago, I opened an individual retirement account at a brokerage

for$2,000. I was not told that because my income is passive, I was ineligible for an IRA. I didn’t find out for several years. What should I do? My tax advisor says I should just let it slide because the Internal Revenue Service isn’t likely to catch it. Is this good advice? Will I get in big trouble when I withdraw the money when I turn 59 1/2?

--P.K.

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A Here are your choices. We’ll let you decide how to proceed.

To be within the strict bounds of the law, you should withdraw the funds in those ineligible IRA accounts, pay a 6%-a-year excise tax for excess contributions and a 10% penalty for early withdrawal, plus ordinary income taxes on the full amount of the withdrawal. Then, carefully clutching the few dollars you have left, you can rest assured that you have made full amends to the government for your $2,000 mistake.

Or you could take a more aggressive position and simply forget the whole matter and let the funds stay where they are. At age 59 1/2, simply withdraw the money and pay the appropriate income taxes on the disbursement. After all, you might reason, the IRS didn’t catch the contribution when it was made.

Further, our experts note that, assuming you have not made additional contributions to the accounts in subsequent years, the statute of limitations on the initial deposits has elapsed.

What does the IRS say? A spokesman said that, officially, the agency can only recommend the first choice. Unofficially and anonymously, he said chances are pretty good that the IRS won’t come looking for you. Besides, he noted, the amount of money at stake here isn’t going to make much of a dent in the national debt.

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Q I have purchased certificates of deposit for each of my five grandchildren under the Uniform Gift to Minors Act. However, I have never told their parents of my actions. This year, some of these accounts will earn more than $500 in interest. Who is required to report this income and pay the taxes, the parents or I?

--I.G.

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A Under the Uniform Gift to Minors Act, taxes on the income generated by irrevocably held trust assets are the responsibility of the recipient, not the donor. Your grandchildren--not you or their parents--should declare the dividends on their tax returns and pay whatever tax is appropriate, provided the dividends or other unearned income total at least $500.

Although you may have been planning to surprise your grandchildren with these investments at a later date, you are probably well advised to disclose these accounts now. You can pay to have their returns prepared and can even pay the required taxes, but if your grandchildren are old enough to write, the law requires that they sign the returns. If you do not want to have the returns prepared and pay their taxes, your grandchildren--no doubt with their parents’ help--will be responsible for these matters.

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Q Over the last several years, I lent my daughter about $100,000 for her education. Now she wants to repay me all at once. Will this pose a tax problem for me? Is it considered income?

--R.D.

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A With one notable exception, being repaid for a loan you made--even if you are paid in one huge lump sum--shouldn’t raise any eyebrows. The only potential issue is whether you charged your daughter interest for the loan.

The IRS allows taxpayers to make an interest-free or low-interest loan of up to $100,000 without having to report the forgone interest as imputed, taxable income. However, that waiver is lost if the borrower’s net investment income exceeds $1,000. If the limit is exceeded, the lender must report the amount of the borrower’s investment income as imputed interest.

Perhaps all this will make more sense once you understand the reason for the rules.

The government does not want taxpayers in lower tax brackets to get low-interest or interest-free loans while they are earning investment income that Uncle Sam cannot get his full share of.

For example, let’s say a couple in the 31% tax bracket lend their college-age son money for school. Meanwhile, the son, a member of the 15% tax bracket, puts the money in his bank account and reports that interest on his tax return. Uncle Sam feels cheated.

If the example seems eerily familiar, you can make it up to Uncle Sam by filing amended tax returns. Our experts say that under the statute of limitations, amended returns would be necessary only for the last three years.

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com