Traditional individual retirement accounts (IRAs) and qualified retirement plans such as Sec. 401(k) plans frequently compose a significant portion of an individual's wealth. These accounts are subject to numerous and, often, complicated rules, and the penalties for failing to comply with these rules can be substantial. This item focuses on some of the more common retirement distribution planning mistakes and suggests ways to prevent and mitigate them. All references in this item to IRAs refer to traditional IRAs and not Roth IRAs.
Failure to Take Required Minimum Distributions and the Excess Accumulation Penalty
One of the most appealing features of IRAs and qualified plans is that they are tax-favored. Income and growth from assets in the accounts are allowed to accumulate on a tax-deferred basis and are not taxed until distributed to the account owner. Congress intended these accounts to be used by the account owner in retirement and not as wealth-transfer vehicles. To prevent the accumulation and transfer of wealth in and from retirement accounts, Sec. 401(a)(9) provides for required minimum distributions (RMDs).
Sec. 401(a)(9)(C) and Regs. Secs. 1.401(a)(9)-5, A-1(b) and (c) require distributions to be made from these accounts to the account owner, generally beginning when the account owner reaches age 70½ or retires, with some exceptions.The first distribution needs to be made by April 1 of the calendar year following the year the owner turns age 70½. This is known as the required beginning date. Going forward, a distribution to the account owner must be made by Dec. 31 of each calendar year, beginning with the calendar year containing the required beginning date. Failure to take RMDs will result in the imposition of a 50% excise tax assessed pursuant to Sec. 4974(a) to the account owner for the shortfall, i.e., the amount that was required to be distributed but was not.
Example 1: M, age 80, owns an IRA. He is over age 70½ and is taking annual RMDs from his retirement account. He was required to take an RMD of $250,000 for 2014 but took a distribution of only $100,000. His RMD shortfall is $150,000 ($250,000 RMD ‒ $100,000 actual distribution). Therefore, he would be subject to $75,000 of excise tax ($150,000 RMD shortfall × 50%) for failing to take his full 2014 RMD.
As is evident in Example 1, the tax imposed for missed RMDs, also known as the excess accumulation penalty, is one of the steepest penalties the Code imposes with regard to retirement accounts. Fortunately, it is also one of the easiest to avoid. Taxpayers nearing age 70½ and those who have already started taking RMDs from their retirement accounts should consult with their advisers to ensure sufficient RMDs are taken when required.
The 50% excess accumulation penalty applies not only to IRA and qualified plan account owners, but also to inherited IRA and qualified plan beneficiaries. Pursuant to Regs. Sec. 1.401(a)(9)-1, A-2(b)(1), the RMD rules apply to inherited account beneficiaries who receive an account due to the death of an account owner. Nonspouse beneficiaries generally are required to start taking distributions from the account by Dec. 31 of the year following the year of the account owner's death. If the RMDs are not taken, the same 50% excess accumulation penalty applies. Spouse beneficiaries who do not roll over the account owner's IRA into their own IRA (as discussed below) are generally required to start taking distributions from the account on or before the later of Dec. 31 of the year following the year of the deceased spouse's death or Dec. 31 of the year in which the account owner would have attained age 70½. Individuals who inherit a retirement account should also consult with their adviser to make sure they are adhering to the RMD rules.
Consistent with the application of many other penalties, Congress provided a mechanism to waive the excess accumulation penalty. Pursuant to Sec. 4974(d), if the taxpayer can establish that the shortfall in the amount distributed during any tax year was due to reasonable error and that reasonable steps are being taken to remedy the shortfall, the IRS has the authority to waive the penalty. Waivers are granted on a case-by-case basis, and the analysis is factual. An excess accumulation is due to reasonable error when it occurs through no fault of the plan participant. Withdrawing the shortfall amount as soon as practical after discovery can show that reasonable steps were taken to remedy the shortfall.
The waiver request is made by filing Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, and attaching an explanation. The taxpayer does not have to pay the penalty as a condition of requesting the waiver. A taxpayer who failed to take an RMD and is subject to the excess accumulation penalty should consult with an adviser to determine whether to file a request for a waiver.
Ensuring RMDs Are Not Overlooked in the Year of an Account Owner's Death
After the death of an account owner, the RMD rules apply to the account beneficiary. This is true even in the year of the death of an account owner who has reached his or her required beginning date (i.e., who is over 70½ and was taking lifetime RMDs).
If the account owner took the full RMD for the year of his or her death, then nothing needs to be withdrawn from the account for the year. However, pursuant to Regs. Sec. 1.401(a)(9)-5, A-4(a), if the account owner died before taking his or her full RMD for the year, then the beneficiary is responsible for taking the balance of the RMD. The executor of the account owner's estate does not need to be concerned about the RMD for the year of the account owner's death unless the estate is the beneficiary of the account.
Example 2: J, who is 80 and owns an IRA, is required to take a $100,000 distribution from her IRA in 2014. J dies in January 2014. She had withdrawn only $10,000 of her 2014 RMD prior to her death. J's beneficiary designation form names her daughter, K, as the beneficiary of her IRA. K, as beneficiary, is required to take the $90,000 balance of the 2014 RMD prior to Dec. 31, 2014. If K does not take the balance by then, she would be subject to the 50% excess accumulation penalty. J's estate is not required to take the balance of the 2014 RMD since it is not the beneficiary.
It is not uncommon in the year of an account owner's death to overlook the RMD or incorrectly assume the balance of the distribution should be taken by the account owner's estate. Therefore, executors of a decedent's estate and beneficiaries of a decedent's retirement account should contact their advisers in the year of an account owner's death to ensure the balance of the year-of-death RMD is not inadvertently missed or taken by the wrong party.
Spousal Rollovers and Avoiding the Spousal Rollover Trap
Pursuant to Secs. 402(c)(9) and 408(d) and Regs. Sec. 1.408-8, A-5(a), a surviving spouse can roll over into his or her retirement account retirement plan benefits left to him or her by a deceased spouse. A surviving spouse is the only beneficiary with this opportunity. All other beneficiaries must treat the account as an inherited account and generally must begin taking distributions from it by Dec. 31 of the year following the year of the account owner's death.
The key benefit of executing a spousal rollover is that the retirement account assets become assets of the surviving spouse, and the surviving spouse is treated as the owner rather than as a beneficiary of the IRA for purposes of the RMD rules. Thus, the surviving spouse will be subject to the RMD rules of Sec. 401(a)(9)(A) and will not be forced to take required distributions from the account until he or she reaches age 70½. However, by treating the retirement benefits as part of his or her own retirement account, a surviving spouse under age 59½ is subject to the 10% early withdrawal penalty under Sec. 72(t) on any assets withdrawn from the account.
This potential trap may be avoided by rolling over a portion of the retirement account while maintaining a portion of the account in the deceased spouse's name. Individuals younger than 59½ who inherit a retirement account from a spouse should contact their adviser to weigh their opportunities and effectively plan future distributions from the account.
As is evident, the distribution rules regarding retirement accounts such as IRAs and qualified plans present many traps for the unwary. The issues presented in this item are just a handful of the common mistakes that can be made with regard to retirement distribution planning. Understanding these rules goes a long way toward preventing and mitigating some of those mistakes.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.