A few years ago, the IRS discovered required minimum distributions (RMDs) were a potential gold mine.
A study of tax returns found taxpayers ages 70½ and older made many mistakes with RMDs from IRAs and employer retirement plans. Recent surveys of taxpayers also reveal that many people aren’t well-informed about RMDs. When the IRS finds a mistake in an RMD, the agency can assess the taxpayer for back taxes and interest. In addition, when an RMD was for less than the required amount, the IRS can assess a penalty of 50% of the difference.
For baby boomers, RMDs are a great disruptor of retirement plans. The longer retirement lasts, the greater the negative effects of RMDs. As the early boomers reach their mid-70s and beyond, they’re in the years when RMDs cause significant tax problems. When I make speaking appearances, I hear a lot of complaints about RMDs and requests for ways to reduce them.
This month, I summarize the most common mistakes, misunderstandings and myths involving RMDs.
Not taking the RMD.
Some people don’t know about RMDs. Others think they qualify for an exception, but it turns out they don’t. The exceptions involve employer retirement plans, such as 401(k)s, especially for someone who’s still working after age 70½.
Details about the exceptions are in our December 2017 issue. A key point is that any exceptions apply only to employer retirement plans, not to IRAs. You might be able to delay an employer plan RMD, but not an IRA RMD.
Rolling over or converting an RMD.
An RMD from a traditional IRA or 401(k) has to be included in your gross income for the year. You can’t avoid taxes by rolling over the RMD amount into either a traditional IRA or an employer retirement plan.
In fact, after age 70½ you aren’t allowed to make contributions to a traditional IRA. If you put the RMD amount in a traditional IRA and try to call it a rollover, you’ll have made an excess contribution to the IRA. If you don’t withdraw it by the end of the year, you’ll owe a penalty.
Not taking the RMD first.
You might plan to convert a traditional retirement account to a Roth account or roll over a 401(k) plan to an IRA. You can do either transaction. But if you’re over age 70½, you must take the RMD first and do your planned transaction with the rest of the account.
The most common mistake is for someone to convert a traditional IRA to a Roth IRA and believe the rollover includes the RMD. You have to take the RMD first and include it in gross income. Then, you can convert any remaining amount in the traditional IRA to a Roth IRA. The RMD amount can’t be rolled over to the Roth IRA.
You might be able to contribute the RMD amount to the Roth IRA, because you’re allowed to make Roth IRA contributions after age 70½. But you must have earned income at least equal to the amount of the contribution.
Also, in 2019 your adjusted gross income can’t be above $122,000 if you’re single or $193,000 for married couples filing jointly.
Improperly aggregating RMDs.
When you own multiple traditional IRAs, you can aggregate the RMDs and take the total from the IRAs in any proportion you want. But RMDs can’t be aggregated for most other types of retirement plans. The RMD must be computed and taken separately from each account. When in doubt, don’t aggregate. See our March 2017 issue for details.
Merging spouses’ RMDs.
One of the more confusing features of our tax code is that sometimes married couples are treated as one unit and sometimes they are treated as separate taxpayers. With RMDs, each spouse is treated separately.
Each spouse separately must compute the RMDs for his or her IRAs and employer accounts. Then, the RMDs must be taken from that spouse’s accounts. There is no merging, combining or linking the accounts of the spouses.
Miscalculating the RMD. This error is becoming less common because many brokers and mutual fund firms are calculating the RMDs and including them on printed account statements and online. Some of the firms display the RMDs more prominently than others.
You still should know how the RMD is calculated and check that the number on the statement is accurate. Though the calculation is simple, many people use the wrong age, life expectancy table or account balance.
Combining multi-year distributions.
The RMD isn’t a limit. You can take distributions of any amount during the year as long as you distribute at least the RMD amount.
Some people believe that if they take more than the RMD one year, they can subtract the excess from the next year’s RMD. That’s not the case. The RMD is calculated separately each year. You get credit for an excess distribution, because the next year’s RMD is computed using the account balance at the end of the previous year.
Confusing the RMD as a QCD limit.
The qualified charitable distribution (QCD) is a great way to make charitable contributions after age 70½. You have IRA money transferred to a charity. That counts toward your RMD for the year but isn’t included in gross income.
The QCD is limited to $100,000 per year per taxpayer. You can give a QCD that exceeds your RMD, if the RMD is less than $100,000. You also can make a QCD that is less than your RMD, but you’ll have to take an additional distribution to make up the balance of the RMD. See our April 2019 issue for details.
Not knowing when cash is required.
With most IRAs, you don’t need to sell assets and have the RMD made in cash. You can distribute property, and the fair market value of the property on the day of the distribution will be the amount distributed.
Most brokers and mutual funds let you transfer shares of stock or mutual funds from your IRA to a taxable account at the firm. That will count toward your RMD without having to change your portfolio.
The story is a little different when you have a true self-directed IRA that holds unconventional assets, such as real estate, interests in a small business, mortgages and similar assets. These assets aren’t liquid and often can’t be divided so that a portion is distributed as an RMD. In that case, the IRA needs cash to make RMDs.
When you have assets such as these in an IRA, you have to ensure there’s enough cash or distributable assets in the IRA to make the RMD.