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George F. Bearup, J.D. Senior Legal Trust Advisor

November 8, 2022

First-Dollars-Out Trap

Take-Away: The timing of when to take the first required minimum distribution (RMD) can create confusion and lead to a possible excise tax for an ‘excess contribution.’ This trap is because an RMD can never be rolled over.

Background: As we have covered in the past, the first-dollars-out rule provides that when a required minimum distribution (RMD) obligation exists, e.g. after the IRA owner or plan participant attains age 72, those dollars receive from the retirement plan are not eligible to be rolled over until the owner/participant’s RMD for the year is satisfied. However, the rules are confusing, and can in the year when the RMD starts lead to a trap.

Trap: RMDs do not have to start until April 1 of the calendar year that follows the year in which a plan participant attains the age 72. That April 1 is considered to participant’s required beginning date (RBD.) Assume a plan participant in a 401(k) retires in 2022 when he/she attains age 72. That ‘retired’ plan participant will have until April 1, 2023 in which to take his/her first RMD (for calendar year 2022.) Can the plan participant roll over the entire balance of his 401(k) account to his/her IRA in 2022 before taking his/her RMD for 2022 by April 1, 2023? Logic would say ‘yes’ since their RBD under the Regulations is April 1 of the following calendar year, 2023. Surprisingly,  the IRS says ‘no,’ the first RMD must be taken from the 401(k) plan before the balance of the 401(k) account can be rolled over to the participant’s IRA- even though their RBD is April 1, 2023.

IRS Reasoning (such as it is:) The IRS provides three reasons for its interpretation of the RMD-rollover rule.

  1. The first funds distributed in a year in which an RMD is required are considered part of the RMD, the now familiar first-dollars-out
  2. The first year in which an RMD is required is not the year of the required beginning date (RBD); rather, it is the year of the participant’s retirement, i.e. the year before the year of the RBD.
  3. Required minimum distributions (RBDs) can never be rolled over.

These three rules lead to the IRS’ conclusion that the first dollars the plan participant takes from his/her 401(k) account in the year on or after age 72 must be part of the RMD and thus  they are not eligible to be a part of an IRA rollover. You will recall that if an RMD is rolled over, it will be viewed as an excess contribution to the IRA that leads to the 6% excise tax for an excess contribution. That excess contribution will have to be returned to the now-retired plan participant by October 15 of the year that follows the year the ‘contribution’ was made to the IRA to avoid the penalty.

Example: Adam is employed and participants in his employer’s 401(k) plan. In 2022 Adam, age 73, finally retires. (Adam qualified for the still working exception to RMDs for his last year of employment.) In 2022, Adam elects to roll over his 401(k) balance of $400,000 to his IRA. Adam understands that he does not have to take his first RMD until April 1, 2023, when he is fully retired and no longer still working. Adam thus rolls over his entire 401(k) balance of $400,000 to his IRA in 2022, including the 2023 RMD amount, which is about $15,000. Since the $15,000 was not eligible for a rollover, it now becomes an excess contribution to Adam’s IRA. Adam can fix the problem without the imposition of any excise tax by withdrawing from his IRA the $15,000  amount, along with any earnings (or losses) in his IRA attributable to that $15,000 by October 16, 2023. While Adam could avoid this problem by delaying the rollover until after April 1, 2023, his RBD according to the IRS, that would also mean that Adam would have to report in 2023 two separate taxable RMDs- the April 1, 2023 RMD which represents the 2022 RMD, and the no-later than December 31, 2023 RMD, which represents the  2023 RMD.

Conclusion: Sadly, the Tax Code provisions that deal with retirement plan contributions and distributions is riddled with such traps as the one just described. Careful planning and an understanding of the ‘rules’ is critical. Relying assumptions and reaching logical conclusions is not always the best way to apply the IRS’ rules when it comes to retirement plans.