How to Avoid Tricks and Traps in Required Minimum Distributions

Required minimum distributions from IRAs and other qualified retirement plans are a source of frequent mistakes. This is an area in which you want to avoid mistakes, because the penalty is steep.

The IRS changed the rules for RMDs in 2001 and 2002. There still are a lot of publications and web sites with the old rules. The computations changed, as did the life expectancy tables. The old five-year distribution rule now applies in only a few situations.

The required beginning date is the starting point and first source of mistakes.
RMDs must begin by April 1 of the year after the IRA owner turns age 70½. Someone who turned 70½ in January 2007 and someone who turned 70½ in December 2007 each must take his or her first RMD by April 1, 2008.

While the first RMD can be delayed until April 1 of the year after turning age 70½, that is not the best strategy. The second RMD must be taken by Dec. 31 of that same year. If the first RMD is not taken until near the deadline, there will be two RMDs taken the same year. That could push the IRA owner into a higher tax bracket, increasing the tax rate on the distributions. Taking two distributions in one year also could cause the loss of tax breaks that are phased out at higher incomes. A better strategy is to take the first RMD by Dec. 31 of the year in which the owner turns age 70½. That spreads the first two distributions over two tax years.

Next the RMD must be computed. This is fairly simple, but IRA owners frequently make mistakes.

To compute the RMD for a year, take the closing balance of the IRA as of Dec. 31 of the year before. Most people then turn to the “Uniform Lifetime Table” of life expectancies contained in IRS Publication 590 (available at www.irs.gov) and also posted on our members’-only web site. In the table, find the number for the IRA owner’s age. Divide that number into the account balance. The result is the RMD for the year. This exercise is repeated each year.

A different life expectancy table is used by a married IRA owner whose spouse is more than 10 years younger when the spouse is the designated primary beneficiary of the IRA. In that case the “Joint Life and Last Survivor Expectancy Table” also located in Publication 590 is used. This table does a more precise matching of the joint life expectancy.

People can get confused about the age to use when consulting the table, particularly for the first RMD. The age to use is the age on the birthday that occurred in the year the owner turned age 70½. If the owner turned age 70½ in the first part of the year, he or she will have a 71st birthday by the end of the year and would use age 71 to determine the first RMD. Someone who turned 70½ in the second half of the year does not have another birthday before the end of the year. That person uses age 70 to compute the RMD.

Another trick with that first RMD is the IRA account balance to use. As mentioned, the tax law allows the first RMD to be delayed as long as April 1 of the year after turning age 70½. Whenever the distribution is taken, however, the account balance used is the balance as of Dec. 31 of the year before turning age 70½.

Suppose Max Profits turned age 70½ on June 15, 2007. He can take the first RMD by Dec. 31, 2007, or can delay it as long as April 1, 2008. In either case, the account balance as of Dec. 31, 2006, is used to compute the first RMD. The second RMD, which must be taken by Dec. 31, 2008, is computed using the account balance as of Dec. 31, 2007.

Because the balance from the previous Dec. 31 is used, in a declining market an IRA owner could be making RMDs based on an account balance that is higher than the current balance.

An RMD cannot be avoided by converting a traditional IRA to a Roth IRA near the end of the year, then converting back to a traditional IRA early the next year. In that case the tax law requires the Dec. 31 IRA balance to be adjusted for any converted amounts that are recharacterized. If the Roth IRA declined in value by Dec. 31, the lower amount can be used instead of the higher amount that was converted earlier in the year.

If a traditional IRA is converted into a Roth IRA, an RMD is required for the year in which the conversion is made, because the RMD is based on the traditional IRA balance as of Dec. 31 of the preceding year.

An RMD also is required for the year of the IRA owner’s death, no matter when during the year that occurred.

The RMD rules apply to all qualified retirement plans: profit-sharing, 401(k), and pension plans, among others. There are some adjustments for different types of plans.

For employer-sponsored plans (but not for IRAs, SEPs, and SIMPLE IRAs), the required beginning date is delayed if the employee still is working for the employer and does not own more than 5% of the employer. In that case, the distributions can be delayed until April 1 of the year after the year in which he or she retires. There also is an exception for money contributed to a 403(b) plan before 1987. Those distributions can be delayed until age 75.

When a person owns more than one IRA, all the IRA balances are aggregated to determine the RMD for the year. The owner can decide to withdraw that amount from the accounts in any proportion he or she wants. All of it can be taken from one account, from all the accounts pro rata, or in different amounts from the accounts. All that matters to the IRS is that the total withdrawn for the year equals the RMD for the aggregated IRAs.

While the RMD rules apply to all types of employer plans, the calculations can be a bit different for plans other than IRAs. For example, when there are multiple employer plans (such as a profit-sharing plan and a 401(k) plan) the distributions are computed and taken separately for each plan; they are not aggregated. Check Publication 590 for details.

There are some additional rules people often overlook.

RMDs do not have to be in cash; they can be in-kind. For example, if the IRA has a stock the owner does not want to sell, shares of the stock can be distributed to the owner. The market value of the stock on the date of the distribution will be the amount of the distribution. Most IRA custodians can set up taxable brokerage accounts and transfer stock or other security from the IRA to the taxable account. This rule also allows the owner to distribute illiquid assets without trying to sell them.

There is no maximum distribution. An IRA owner is free to withdraw amounts exceeding the RMD for any reason. An excess distribution does not result in any credit the following year. The adjustment is automatic because next year’s RMD is determined by using the account balance as of the end of the current year.

An employer-sponsored plan can impose stricter rules than the IRS imposes. Some employer plans require retired employees to withdraw or roll over their account balances within five years or have other restrictions.

RMDs can be taken at any time during the year and on any schedule. The IRS’s only requirement is that at least the full amount be distributed by Dec. 31. The owner can take the amount in a lump sum, fixed installments, or periodic withdrawals at whatever times and in whatever ways suit his or her needs.

The RMD cannot exceed 100% of the account balance. If investment losses or other events cause the account to decline below the RMD amount, the account only needs to be brought to zero.
RMDs are imposed on beneficiaries of inherited IRAs, but the rules are different. We have covered those in past visits and will update them in the future. Owners of Roth IRAs are not required to take RMDs, but beneficiaries who inherit Roths must take RMDs.

The penalty for failing to take the proper RMD is 50% of the amount that was supposed to be distributed but was not. The 50% penalty is a holdover from when the top tax rate was 50%. It was not adjusted when the top tax rate declined. A penalty can be waived by the IRS if it determines that the failure was due to a reasonable cause. The penalty is reported and a waiver requested by filing Form 5329.

To avoid the penalty, calculate RMDs for all accounts early in the year. The calculations can be made as soon as the Dec. 31 balances are known. Set up a withdrawal plan that satisfies the RMDs. Monitor the situation in the last quarter of the year to ensure that at least the RMD will be distributed from each plan.