Take-Away: Planning for retirement account distributions is critical in light of the amount of wealth now held and accumulated in qualifed plans like 401 (k) accounts and IRAs. Unfortunately, the distribution rules are complex, and several have timing rules that are inflexible that can lead to the assessment of penalties. As a result, it is important to pay close attention to these timing rules.

Background: What does not help is that some IRS timing rules are well known,  but they are inapplicable to other types of distributions, or occasions that permit a retirement plan distribution without penalty. Perhaps the most well known distribution timing rule is that required minimum distributions (RMDs) must be taken the year in which the IRA owner or qualified plan participant turns age 70 1/2, but that first required distribution can be delayed until the following April 1. The confusion occurs when this year in which requirement (or latitude) with regard to RMDs is applied to other distribution events. A few examples follow:

Qualifed Charitable Distributions: This now popular planning opportunity permits an IRA owner to directly transfer up to $100,000 of his/her annual RMD obligation to a charity and have that distribution apply towards their RMD for the calendar year. The amount transferred to the charity is not included in the IRA owner’s taxable income for the year resulting, in effect, in a 100% charitable income tax deduction. But the IRA owner must actually be age 70 1/2 when they direct their IRA custodian to write a check to the charity. Just because the IRA owner will turn age 70 1/2 in the year in which the Qualified Charitable Distribution is made is not enough. The IRA owner must actually be age 70 1/2 when the Qualified Charitable Distribution is made from his/her IRA account. If the check is written prior to that age, then it will be treated as a taxable distribution to the IRA owner, and thus included in the owner’s taxable income for the calendar year.

Example: Carol turns 70 on February 15, 2019. Carol has a capital campaign pledge outstanding to her church. Carol directs her IRA custodian to write a check to the church on June 30, 2019 to fulfill her capital campaign pledge. The distribution from Carol’s IRA will be taxable to her and reported as part of Carol’s income for 2019. Carol was not age 70 1/2 on June 30 when the check was written from her IRA and delivered to her church. Had Carol waited until August 15 to have the check written from her IRA and made payable to her church, it would have been treated as Carol’s RMD for 2019 and she would not have had to report the distribution as part of her taxable income for the year. [While Carol may be able to deduct the amount of the check delivered to the church as a charitable contribution, in light of the larger standard deduction available for 2019 there is a good chance Carol will not itemize her income tax deductions for 2019, meaning that there will be no charitable income tax deduction available to her for the year attributable to Carol paying her church pledge.]

Avoiding the 10% Early Distribution Penalty: Another well known rule with regard to retirement plan and IRA distributions is that the plan participant or IRA owner may withdraw retirement funds without the 10% penalty for early distributions if they are age 59 1/2. Again, like the Qualified Charitable Distribution, the withdrawal from the qualified plan or IRA can only be taken when the participant/owner is actually age 59 1/2.

Example: Charlie turns age 59 on March 1, 2019. Charlie takes a distribution from his IRA on April 30 to pay off his mortgage. Charlie turns age 59 1/2 on September 15, 2019. Charlie thinks that his IRA distribution on April 30 will be without penalty because 2019 is the year in which he turns 59 1/2. Charlie is wrong in his assumption. As a result, the distribution that Charlie takes from his IRA on April 30 to pay off his mortgage will be subject to the 10% excise tax (call it a penalty) assessed on the amount that he withdrew from his IRA.

Termination of Employment: One exception to the normal limitations on a distribution from a qualifed plan prior to the participant being age 59 1/2 is when the participant terminates employment with the qualifed plan sponsor at age 55. The termination of employment exception can apply if the employee quits their job, they are fired, or they decide to retire. This exception applies only to plan participants, not to IRA owner, nor to amounts that originated in a qualified plan account that were subsequently rolled over into an IRA. Under this exception the plan participant must be age 55 years and when the termination of employment occurs.

Example: Ned quits his job at age 53 years. When Ned attains age 55 years, he starts to take distributions from his qualified plan 401(k) account (i.e. there was no rollover of Ned’s account balance to an IRA.) Ned, age 55 years old, who terminated his employment, thinks he satisfies the age 55 exception. Ned is incorrect. While Ned waited until he was age 55 to take a distribution, Ned terminated his employment when he was age 53, not when he was age 55. In short, Ned’s employment did not terminate when Ned attained age 55 years. The distributions to Ned are subject to the 10% penalty for early distributions. Watson v. Commissioner, Tax Court Summary Opinion, 2011-113 (September 28, 2011.)

Conclusion: These are just a few examples of where an individual made an assumption with regard to retirement plan distribution exceptions that went awry. The point is to pay close attention to the conditions imposed for an exception to the normal distribution rules and penalties, and in particular the timing requirements imposed on those conditions.