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

8-Sep-16

IRA and Qualified Plan Required Distributions: Tricks and Traps

All of us have a fairly comfortable with our working knowledge of IRA distribution rules and rollovers from IRA accounts. But sometimes that familiarity with the basic distribution rules can cause us to become a bit too complacent and make assumptions that are not always accurate. Complying with these rules is critical since the penalty for not taking a required minimum distribution is 50% on the amount that that is not withdrawn by the IRA or retirement account owner.  Some of the mistakes that advisors might make when they in provide guidance on retirement plan distributions include the following:

  1. Trap-Age 70½ Required Beginning Date- Income ‘Bunching’: The basic rule is that the first required minimum distribution must be taken by April 1 of the year after which the IRA owner attains the age 70½. Opting to delay taking a distribution can cause confusion. If the owner’s 70th birthday falls between January and June, the year of their 70th birthday will be their first distribution year. If the owner’s birthday falls in the balance of that calendar year then the year in which the owner attains age 71 will be the owner’s first distribution year. But the trap is when the IRA owner delays taking their first distribution until April 1 of the following year. The trap is that the prior year’s distribution will be taken on or before April 1, but then the IRA owner will have to take a second required minimum distribution before December 31 of that same calendar year. In other words two required minimum distributions will be taken in the same calendar year, which will bunch the two taxable distributions in the same tax reporting year, and possibly expose that bunched taxable income to a marginally higher federal income tax rate.
  2. Trap-The ‘Still Working’ Exception- The 5% Owner Rule: A statutory exception to the obligation to take a required minimum distribution from a qualified plan once the plan participant attains age 70½ e.g. from a 401k plan account, is if the participant is still working for the plan sponsor and the participant is a less than 5% owner of the plan sponsor. The trap is only looking at the participant’s ownership interest in the plan sponsor. Other related persons to the participant e.g. spouse; children; grandchildren, and entities controlled by the participant e.g. a trust or partnership, must be added together to determine if the participant’s ownership percentage does not exceed 5% in order to permit a delay in the taking the first required minimum distribution. Note that this exception applies only to non-IRA based employer sponsored retirement plans; an employee who participates in a SEP IRA or a SIMPLE IRA self-employed is not eligible to delay their first required minimum distribution beyond age 70½.
  3. Trap-The ‘Still Working’ Exception- Ownership Snapshot Test: The less than 5% ownership exception is not an on-going ‘test.’ It is only the last day of the calendar year in which the participant attains age 70½ that is used to determine if more than 5% ownership of the plan sponsor is held by the participant. Even if in later years the participant gifts or sells some of their interest in the sponsor, thus taking their ownership interest below the magical 5% ceiling, it will be too late. Future ownership divestiture is ignored in calculating the 5% ownership limit; it is only the year in which age 70½ is reached that determines if this statutory exception to take a required minimum distribution applies.
  4. Trick-403(b) The ‘Old Money’ Exception: One of the quirks found in the required minimum distribution rules [there must have been a strong teacher’s lobby in 1987!] is that money that was contributed to a 403(b) tax sheltered annuity prior to 1987 is not subject to the mandatory required minimum distribution age of 70½. Rather, the annuity owner can delay taking distributions until he or she attains age 75 years. While this is an opportunity to avoid having to start to take required minimum distributions from a 403(b) tax sheltered annuity, it is only the amount that was contributed to the annuity prior to 1987 that qualifies for the statutory exception. More importantly, the earnings on those pre-1987 403(b) contributions are not protected by the exception either, which makes this a very narrow loophole to the normal required minimum distribution rules.
  5. Trick and Trap-The Purchase of a Qualifying Longevity Annuity Contract: In 2014 final Regulations were published that permit a portion of an IRA or qualified retirement plan account to be invested in a qualified longevity annuity contract (QLAC.) The account owner can invest up to $125,000 of their IRA or retirement account in a QLAC which will not have to become annuitized until the account owner attains age 85 years. The amount invested in the QLAC will excluded from the owner’s account balance on December 31 which is to determine the next year’s required minimum distribution amount-the amount in the QLAC is ignored for the next year IRA distribution calculation. The trick is if the QLAC is purchased prior to the owner attaining age 70½ which (hopefully) grows in value until the owner reaches age 70½; if so, the full investment in the QLAC and its post-purchase earnings will be ignored when the owner’s first required minimum distribution is calculated (the initial investment and its post-investment earnings are both ignored.) In contrast, the trap is when the QLAC is purchased in the year that the IRA owner attains age 70½; the investment made to purchase the QLAC in that year will be ignored when the IRA owner calculates his or her first year required minimum distribution amount. Example: Assume I turn 70½ on December 1 of 2016. My IRA account balance was $850,000 on December 31, 2015. I must withdraw $31,022 from my IRA this year [$850,000 divided by 27.4 years [my life expectancy under the IRS tables] = $31,022.] During 2016 I decide to purchase a $125,000 QLAC using my IRA account funds. I still must take my $31,022 required minimum distribution, even though my IRA account is substantially lower at the end of 2016 due to my purchase of the $125,000 QLAC. If an IRA owner or qualified plan participant will receive substantial taxable income when they attain age 70½, such as the receipt of deferred compensation benefits, then the purchase of a QLAC prior to that age will reduce their required minimum distribution and possibly keep their taxable income at a lower marginal income tax bracket.
  6. Trap-Treating a Required Minimum Distribution as a Rollover: The fundamental rule to keep in mind is that a required minimum distribution amount can never be treated as a From this basic rule several traps arise:
  • First Money Out: An IRA owner or plan participant cannot make a 60 day rollover of funds until after the required minimum distribution is taken for the year in which age 70 ½ is reached. Thus, the first money out of the retirement account must be treated as the owner’s required minimum distribution. As noted, required minimum distributions cannot under any circumstances be rolled-over. Assume that I turn 70½ and I want to rollover my entire $850,000 IRA into a new IRA. If I roll over the full $850,000 into a new rollover IRA, and I do not withhold $31,022 as my required minimum distribution for the year, then I have just made an excess contribution to my new IRA. That IRA contribution to my IRA then triggers a 6% annual penalty for my excess contribution to the IRA, which penalty will continue to be assessed if it is not rectified by October 15 of that year- a penalty that will be assessed each year until mistake is rectified.
  • Qualified Plan Account Rollout: The same problem can arise if I transfer the entire balance of my 401(k) qualified plan account directly to a rollover IRA when I reach 70½. That rollout will be treated as a distribution and under the tax code. Accordingly, if I transfer my entire 401k account balance directly to a rollover IRA when I retire at age 70½, I will make an excess contribution to my IRA, again triggering the 6% penalty. Thus, I need to take my required minimum distribution for the year before the balance can be placed in my rollover
  • Roth Conversion: Assume that I want to make a Roth conversion of some of my IRA account balance. I cannot make a Roth conversion before I take my required minimum distribution since I am 70 ½ years old. Since a Roth conversion is treated as a rollover, and a required minimum distribution can never be treated as a rollover, I must take my required minimum distribution from my IRA first, before I can ever move any other IRA funds into a Roth IRA account. Restating this rule, a Roth conversion is treated as a rollover from a non-Roth IRA to a Roth IRA account. Required minimum distributions can never be rolled over; therefore, the corollary is that a required minimum distribution can never be converted to a Roth IRA. If this rule is violated, i.e. the required minimum distribution amount is deposited into the Roth IRA on a conversion, and then an excess contribution will be made to the Roth IRA with the 6% penalty assessed. The message is pretty clear that before any Roth conversion is considered by an IRA owner or plan participant who is age 70½, the owner must first take their required minimum distribution for the calendar year before the balance of their IRA account is converted into a Roth IRA.
  • An innocent mistake often made is when a 70½ year old IRA owner decides that they want to make a partial conversion of their IRA account to a Roth IRA account. Back to my example: I turn 70½ this year. My IRA is worth $850,000. I must take $31,022 as my required minimum distribution for the year. But I am also eager to fund a Roth IRA to get my money working for me in an income-tax free environment. Assume the first money that I pull from my IRA account this year (say $100,000) I convert to my new Roth IRA. I then take my required minimum distribution for the year from my IRA of $31,022 after my Roth partial conversion. Alas, since the first money out of my IRA each year is considered to be my required minimum distribution, part of my $100,000 Roth conversion amount results in me using my required minimum distribution amount as a rollover, but that amount can never be converted to or rolled over into any new retirement account. Thus, I will have made an excess contribution to my new Roth IRA account, and a 6% excess contribution penalty [6% X $31,022= $1,861.32] will be imposed.
  1. Trap-Qualified Charitable Distribution Age Requirement: We know that last December Congress made the qualified charitable distribution permanent, as opposed to annually extending that opportunity. Under this rule an IRA owner who is 70½ years of age can direct the distribution of up to $100,000 a year from an IRA to a tax exempt entity and have that direct payment satisfy all, or a portion of, that IRA owner’s required minimum distribution. While no charitable income tax deduction can be claimed for the direct payment, the distribution will satisfy the IRA owner’s required minimum distribution for the year. The direct distribution will not be included in the IRA owner’s taxable income for the year, which might help to preserve some tax exemptions, deductions credits, avoid tax deduction phase-outs, and possibly avoid the Medicare 3.8% surtax. The trap is easily described: the qualified charitable deduction can only be made when the IRA owner is age 70 ½. It is not the year in which the IRA owner attains age 70½. Rather, the IRA owner must actually be age 70½ before he or she becomes eligible for this opportunity. If the direction to the IRA custodian to transfer the IRA funds to a tax exempt entity is made prior to the owner attaining age 70½ years, then the distribution will be treated as a taxable distribution to the IRA owner, with a corresponding income tax charitable deduction to the tax exempt entity, but with the loss of some of the income tax benefits described above due to the higher reported taxable income for the year.
  2. Trap- Qualified Charitable Distributions of ‘Tainted’ Amounts: To qualify for the charitable IRA distribution to a tax exempt entity [private foundations and donor advised funds do not qualify] the IRA owner may only use taxable amounts accumulated in the IRA. If, in prior years, the owner made nondeductible contributions to his or her IRA, they have tainted their IRA. Thus, they are not eligible to make a qualified charitable distribution from their IRA. Unlike other rules the IRS has given us where deductible and nondeductible contributions to a single IRA are prorated when distributions are made from that IRA, none of those pro rata rules apply to an IRA that contains a mix of deductible and nondeductible contributions as the source of funds for a qualified charitable distribution. If nondeductible contributions were made to the IRA, then the IRA cannot be used for qualified charitable distributions.

While we have had IRAs for over 40 years now, and an extraordinary amount of wealth is held in IRAs, the IRS does not seem to be all that eager to simplify the IRA distribution rules. Sometimes it feels as if the IRS is intent on playing a gotcha game with taxpayers who want to take advantage of some of the new IRA opportunities that Congress has created since 1974, e.g. Roth conversions; qualified charitable distributions. What is important to remember in navigating all the gotcha rules is that a required minimum distribution is not capable of being rolled over into another IRA.