Its October, the time of year when kids have fun getting lost in cornfield mazes. The same can be said when it comes to advisors who wander into the maze of the IRS’ required minimum distribution rules. Unfortunately those rules are not nearly as much ‘fun’ to navigate as a cornfield maze.

Penalties: Let’s start with why it is not fun getting lost in the required minimum distribution rules maze. First, if the retirement funds are transferred into the wrong retirement account, a 6% penalty is imposed if the transfer is not corrected by October 15 of the following calendar year for the excess contribution. Just pulling the excess contribution out of the IRA by the following October 15 [‘no harm, no foul’] is not enough; gains on the  excess contribution amount must also be pulled out. Then there is the obligation to inform the IRA custodian that the funds pulled out of the IRA represents a return of an excess contribution so it can be correctly reported to the IRS. Second, if the required minimum distribution funds are not timely withdrawn from the retirement account, then there is a 50% penalty imposed on the amount not taken each year until the required minimum distribution is actually taken, not to mention interest imposed on the failure to take the required minimum distribution, and if the RMD amount is large enough, additional accuracy-related penalties can also be imposed. In short, to avoid these excise tax penalties it is critical to both: (i) take the required minimum distribution for the calendar year when it must be taken; and (ii) take the required minimum distribution amount from the correct retirement account. It is the second step that quickly can get you lost in the maze.

RMDs: To calculate the required minimum distribution (RMD) for a calendar year, each separate retirement account, e.g. IRA, SEP IRA, SIMPLE IRA, 403(b), 401(k) must have its own RMD calculated. Then, if aggregation is permitted, the total amount of the required minimum distribution from the several accounts can be taken from a single retirement account. But traps are everywhere when you try to implement these seemingly simple rules.

First Dollars Out Trap: Suppose the IRA owner has an IRA CD which comes due on February 1, and the owner is subject to the required minimum distribution (RMD) rules for the year since the owner is over the age 70.5. The first dollars that come out of a retirement account CD when the owner is subject to the required minimum distribution rules cannot be rolled over. The IRA CD proceeds are RMD assets that cannot be rolled over to another IRA in 60 days. When the IRA owner places the CD proceeds in another IRA  that will result in the imposition of the 6% excess contribution penalty. Note the same results occurs if the owner holds a 401(k) account, if the owner is over age 70.5- the first dollars that come out of the owner’s 401k account are RMD dollars that cannot be rolled into an IRA. In short, if the retirement account owner is over age 70.5 he/she must hold onto the retirement funds taken as a distribution, since none [up to the RMD amount] will be available to be deposited/rolled over into another retirement account.

Commingling Different Accounts Trap: Suppose the IRA owner also owns a 401(k) account. The RMDs must be calculated for both the IRA and the 401(k) account separately. But the RMD for the IRA cannot be taken from the 401(k) account, or vice versa. The general rule is that RMDs for one type of retirement account cannot be taken from a different type of retirement account. If, following the example,  the aggregate RMD is mistakenly taken all from the owner’s IRA account [leaving 100% of the 401(k) account balance intact] then a 50% penalty is imposed on the RMD amount that should have been distributed from the 401(k) account. No credit or ‘Brownie Points’ are awarded for taking the correct RMD amount, albeit all from the wrong (different) account.

In contrast, if the IRA owner has two separate IRAs, then the two separate calculated RMDs from the two IRAs can be aggregated into a single RMD amount, and the entire RMD amount  can be taken from either of the two IRA accounts. A similar aggregation rule applies to 403(b) accounts that are subject to the required minimum distribution rules.

If the regular IRA owner also owns a 403(b) account, the two separately calculated RMDs cannot be taken from either the regular IRA or the 403(b) account; a RMD must be taken from each separate account as the regular IRA and the 403(b) accounts are different.

To make life really interesting, if the owner has two separate 401(k) accounts from separate sponsoring employers, the RMD must be taken from each of the separate 401(k) accounts, even though the two accounts are both the same type of qualified plan (they are 401(k) qualified plans. The RMD must be calculated separately for each individual qualified plan account and the calculated RMD must be taken from each separate qualified plan account- there is no aggregation. If the combined RMD amount is distributed from a single 401(k) account, a mistake that regularly occurs, a 50% penalty will be imposed for the failure to take the RMD from the one 401(k) account that was left whole. Again, no credit or ‘Brownie Points’ are given to the taxpayer who pays the correct amount, but makes the mistake of taking the RMD from the wrong account.

While a SEP IRA is considered to be an employer plan [akin to a qualified plan], it is also considered to be an IRA from RMD purposes. Consequently, if there is a SEP IRA and a regular IRA that are both owned by the same individual, then the combined RMD can be withdrawn from either [SEP or regular] IRA account.

Observation: One would think that so long as Treasury received the correct amount of income tax attributable to the taxpayer’s RMD for the calendar year, regardless of its source, it would be happy, but merely receiving the correct amount of income tax apparently is not enough in light of this fixation on the same source of the RMD. Are we financing the government on arcane traps intended to trigger penalties?

Inherited IRA Traps:  Recall that the required minimum distribution rules apply to an inherited IRA, regardless of the age of the non-spouse IRA beneficiary.  An inherited IRA by a non-spouse beneficiary can only be moved by a direct transfer from custodian to custodian by the inheritor; there are no 60 day rollovers available. A distribution that is payable directly to the inherited IRA beneficiary is a taxable to the beneficiary.

Inherited IRAs follow the same aggregation rules as regular IRAs, where the aggregate RMD from the two inherited IRAs can be taken from only one of the two inherited IRAs, but only if two conditions are met: (i) the inherited IRAs are from the same deceased individual, and (ii) the RMDs will be calculated using the same life expectancy factor.

If I inherit an IRA from my father, and I inherit an IRA from my mother, I cannot aggregate the RMDs from the two inherited IRAs, and take the entire RMD distribution from only one of the inherited IRAs, because the IRAs are not inherited from the same person.

If I inherit a regular IRA from my father, and I also inherit a SEP IRA or a SIMPLE IRA from my father, I can consolidate them for purposes of taking the RMD from only one of them- while they are not exactly the same type of IRA, they both came from the same person, such that they can be aggregated and the RMD is taken only from one of the inherited IRAs.

Along these same lines, if two inherited Roth IRAs come from the same deceased Roth IRA owner, they can also be aggregated for purposes of taking the RMD from only one of the inherited Roth IRAs.

Conversely, if I am the beneficiary of two inherited Roth IRAs, one created by my late father and one created by my late mother, I must take the RMD from each of those two inherited Roth IRAs- back to the same person limitation.

Consider yet another example with inherited IRAs. Assume that I inherit an IRA directly from my father and I begin to take required minimum distributions from it. I also own my own regular IRA. Under both of these IRAs (inherited and regular) I name my wife as the beneficiary. I die (it’s bound to happen someday!). My wife inherits both of these IRAs. My wife cannot aggregate the RMDs from these two IRA when she takes her RMD. The regular IRA that my wife inherits, if not rolled over, will have its RMDs based upon her own age. The inherited IRA that originated with my deceased father will continue to have its RMDs based upon my age, even though the distributions will now be made to my surviving spouse. While my wife is the successor beneficiary of both IRAs, the RMDs will have to be calculated separately  and taken from each separate IRA, not just from one inherited IRA.

Source Trap: Yet another trap occurs when the source of an inherited IRA is traced for RMD purposes. Suppose my father dies and names me as the beneficiary of his regular IRA. My late father also owned 2 other IRAs, but he made those other two IRAs payable to his revocable Trust. My father’s Trust directs that upon his death, his Trust’s assets (including the two IRAs payable to it) are to be distributed to his three children, one of whom is me. Upon my father’s death I receive three IRAs, one that I directly inherited from him on his death since I was its sole named beneficiary, and indirectly I share in the other two other IRAs that come to me through his Trust. All three are inherited IRAs for which I have to take a RMD. But here is the rub: I must take a RMD from two of the IRAs,  one that is sourced to the inherited IRA for which my deceased father named me as its sole beneficiary, and another RMD that is attributable to the two IRAs that have as their ‘source’ my late father’s Trust. The three IRAs are not treated as being inherited from the same person, which thus compels that there must be two separate RMD distributions, one from the directly inherited IRA, and one from the other two IRAs  (which can be consolidated for RMD purposes since they both came to me from the same source, my late father’s Trust.)

It is not an understatement that these RMD rules are overly complex and often contrary to common sense. But then again, one can never assume that the R in IRS to stands for ‘rational.’