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

7-Aug-17

RMDs: End of the Line Tricks and Traps

Take-Away:  As a client reaches age 70 and faces the obligation to take required minimum distributions (RMDs),  these rules are bewildering, which can lead to some traps that cause penalties, or they can offer a creative way to defer reporting the RMD as additional taxable income with the still working exception to the RMD rules.

Background: We are all familiar with the obligation to take an RMD by April 1 of the calendar year following the year the taxpayer attains age 70 ½ years. The failure to take the RMD leads to a 50% penalty assessed on the amount that should have been taken from the qualified plan account or IRA but was not. As such, playing fast-and-loose with the RMD rules is no laughing matter when a 50% penalty is involved. Some key rules that pertain to RMDs to keep in mind  that lead to some of the traps and few tricks associated with RMDs follow:

  • April 1- One Time Event: An RMD is required by April 1 of the year the IRA or retirement plan owner reaches age 70 ½. But that is the only time the April 1 deadline is pertinent. All future RMDs must be taken by December 31 of each following calendar year.
  • Avoid Bunching: If the first RMD is deferred until April 1 of the following year, that will result in a bunching of taxable income into that single tax year for the taxpayer (the year 70 ½ RMD year and the year 71 RMD will be aggregated into the age 71 year.) This results in a bunching of income with possible exposure to higher marginal income tax rates.
  • Snapshot Value: The RMD is taken as a snapshot of the value of the retirement account or the IRA on December 31 of the prior year, regardless of the growth or additional contributions made to the account after the snapshot date. .
  • First RMD Calculation: Once the age 70 ½  is reached, it is the prior year end’s account balance that is used to calculate the taxpayer’s first RMD. Any contributions to the account during the following 70 ½  calendar year are ignored for purposes of calculating the taxpayer’s first RMD for the year.
  • RMDs Cannot be Rolled Over: The first money that comes out of a qualified plan after 70 ½ years of age is not capable of being rolled over into an IRA- it is a taxable RMD to the participant for that year.
  • Mandatory Withholding: There is no mandatory 20% withholding tax on an RMD distribution since an RMD distribution cannot be rolled over.
  • Still Working Exception: If the plan participant is still working at age 70 1/2, and the participant does not own more than 5% of the employer-plan sponsor, then the RMD for the qualified plan is suspended until the participant terminates their employment.
  • Still Working RMD: When the still working participant terminates their employment,  their first RMD must be taken by December 31 in the year of their employment ends.
  • Still Working IRAs: The still working deferral rule does not apply to the participant’s separate IRAs, for which a RMD must be calculated and distributed (to avoid the penalty).
  • Still Working Definition: Neither the Tax Code, nor the IRS in its Regulations, specify what still working actually means, e.g. 40 hours a week? One day a month?.
  • Deceased Participant:  The RMD rule applies only if an employee dies on or after the employee’s RMD.

Trap #1:  The Employee is age 73 but still working. The Employee plans to fully retire at the end of the calendar year. In August the Employee moves $75,000 from her 401(k) account into her IRA, and she retires at the end of the year with the intent to roll the balance of her 401k account balance in to her IRA sometime in the next calendar year. The transfer of the $75,000 in August is considered to be a rollover by the Employee. But RMD’s cannot be rolled over. The first funds out of the 401(k)  plan are considered RMDs. Even though the Employee could have deferred the RMD until April 1 of the following calendar year, the first dollars distributed from the qualified plan in the year the Employee  retired are treated as an RMD. Thus, the Employee will have to pay an income tax on the $75,000 distribution; it is a taxable distribution, not a rollover amount.

Trap #2: Same facts as above, but the Employee moves her entire 401(k) balance to an IRA without taking any RMD. Now the Employee has an excess contribution to her IRA, since part of the rollover was her RMD for the year of her retirement. This problem cannot be corrected merely by the Employee removing the excess contribution amount from her IRA account. The Employee will also have to calculate the earnings on that excess contribution, and a new Form 1099-R will have to be prepared to show the return of the excess contribution and its earnings to the Employee, as a separate amount. The Employee will have until October 1 of the following year to fix this problem in order to avoid the 6% penalty on the excess contribution to her IRA.

Trap #3: Assume the Employee, age 70 1/2, wants to expand on some of her investment options that are not available under her 401(k) plan. So the Employee moves $150,000 of her $600,000 401(k) account balance to an IRA in July which has more flexible investment options available to her. The Employee is then, to her surprise, laid off in November. Therefore the Employee is separated from service in November. The Employee will be treated has having received an RMD from the 401(k) plan because she has separated from service in the calendar year. Recall that the first dollars out of the qualified plan when after reaching age 70 1/2 are treated as an RMD. The Employee now has an excess contribution in her IRA which will have to be removed by the following October 1, or she will face the excess contribution 6% penalty on what should have been her RMD for the year.

Trap #4: The Employee is age 70 in January. Age 70 ½ is reached in July of that year. The Employee dies in December of the same year. The Personal Representative of the Employee’s estate takes an RMD before the close of the year, believing that one must be taken, as the Employee died after 70 ½.  But because the Employee died before her RMD (April 1, of the following calendar year) there is no RMD for the year of death. Thus, income taxes are required to be paid on the amount the Personal Representative withdrew from the qualified plan, when in fact the named beneficiaries of the Employee’s qualified plan could have engaged in a rollover of the distributed amount to an inherited IRA and deferred some of the taxes.  In sum, if a plan participant dies before their RMD, there is no RMD for the year of death with which to contend. The named beneficiary (hopefully there is one) can make a direct rollover of the entire account balance to an inherited IRA. Note that if the Employee died after her RMD then the designated beneficiary (not necessarily the Employee’s estate) is responsible for taking the RMD for the year of death if the deceased Employee had not yet taken the RMD prior to her death.

Trap #5: The Employee, age 70 ½,  dies before taking their RMD from their employer’s qualified plan. Assume that the qualified plan account is not rolled over until the year after the Employee’s death. All of the account balance is transferred into the designated beneficiary’s inherited IRA. Remember that an RMD cannot be rolled over. The plan administrator should send two checks to deplete the deceased Employee’s qualified plan balance. One check, equal to the Employee’s RMD amount, should be sent directly to the named beneficiary. The balance of the deceased Employee’s qualified plan account should be distributed directly to the custodian for the new inherited IRA. If the RMD gets rolled directly into the inherited IRA, it creates an excess contribution; adding to the problem is that  inherited IRAs are not supposed to have any excess contributions- or contributions of any type for that matter.

Trick #1:   The Employee age 72 is still working. He wants to make a creative ‘sure thing’ investment using some of his accumulated 401(k) retirement assets. The Employee opens a self-directed IRA account, his first IRA. He then moves $50,000 from his 401(k) account balance to the newly opened IRA. He then uses the funds in the new IRA to make the ‘sure thing’ investment. The Employee does NOT have an RMD for the year. Why? He is still working so there is no RMD associated with his 401(k) account. As for his self-directed IRA, it did not even exist on the snapshot date of December 31 of the prior calendar year; consequently,  there is no RMD for the IRA for the year in question. (Next year there will be an RMD associated with the IRA, and it might be a challenge to figure out the value of the ‘sure thing’ investment the Employee made with the $50,000 on the following December 31.)

Trick #2:  The Employee is almost 69+ years, nearing his RMD obligation. He has an IRA that he established years ago; he had rolled into that existing IRA his 401(k) account balance from a prior employer. He is still working, albeit for a new employer, and he participates in the new employer’s qualified plan. Normally, the Employee would have to take an RMD from his IRA. However, his current employer’s qualified plan permits the transfer in of other retirement accounts, including IRAs. So the Employee rolls into his employer’s existing qualified plan his IRA account balance. By moving his IRA pre-tax funds into his employer’s qualified plan, the Employee can avoid RMDs for both his IRA funds as well as his current 401(k) account balance, as he is still working. No RMD will have to be taken until the Employee terminates employment.

Conclusions:  More Americans are working beyond reaching social security age and well into their 70’s. The still working exception to the RMD rules is an opportunity to not be overlooked if the employer’s qualified plan accepts the transfer in of another retirement plan or IRA. Remember, however, that the 5% ownership limitation for the still working exception carries with it attribution rules, so that if the employee has other family members who are owners of the plan sponsor, their ownership interests will be attributable to the still working employee, and he/she may not be able to satisfy the less than 5% ownership condition. Finally,  by not following the technical RMD rules on distributions in the year of retirement it may be easy to trigger an excess contribution penalty for transfers into the IRA; the first dollars out of the qualified plan are  RMDs which cannot be rolled over into an IRA.