Avoiding RMD mistakes

By Ed Slott, CPA

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Once again, the single biggest IRA issue that was discovered at tax time was missed required minimum distributions (RMDs), both for IRA owners and beneficiaries.

Not only is this still the single biggest IRA mistake, but missing a required minimum distribution also carries one of the biggest penalties in the tax code. It’s a 50 percent penalty on the amount of an RMD that should have been withdrawn but wasn’t. But the penalty can be waived by making up the missed distribution and asking the IRS to abate the penalty. The penalty is commonly waived for good cause, but the missed RMD still must be taken.

It seems hard to figure out how RMDs are missed when each financial institution sends notification to IRA owners subject to RMDs. If an IRA owner who is subject to RMDs has 10 IRAs, he will have received 10 letters from his banks, brokers and fund companies alerting him to his RMD requirements. Even though the IRA custodians have been notifying IRA owners about their RMDs, they are still missed or forgotten, or incorrect amounts are withdrawn.

So how can RMDs be missed or messed up like this?

Some people just don’t open mail from their financial institutions. They see that the letter is from their bank, so they don’t open it. They put it in a file to save for their accountant at tax time. Then, at tax time, when the accountant has seen the letters and asks about it, the missed RMD is brought to light. Other times, people tell us they treat the mail like junk mail. They say they receive so much mail from financial institutions that they disregard most of it. In some cases, they just throw it away!

There has to be a better way, and there is. It’s a matter of alerting clients and monitoring the RMDs. Every advisor should be doing this to avoid these last-minute revelations.

RMD basics for IRA owners and plan participants

You can’t keep your money in your plan forever. That’s why there is a required beginning date (RBD) and the 50 percent penalty for not taking RMDs. Calculating the first required distribution can be a bit confusing, mainly because the rules for the first RMD are slightly different than the rules for all future RMDs.

Required beginning date

Your first RMD should be taken by Dec. 31 of the year you turn 70½. However, the date you must begin RMDs is generally April 1 of the year following the year you turn 70½. If you turn 70½ at any time in 2007, your RBD is April 1, 2008. If you wait until 2008 to take that first RMD, you have to also take a second RMD by Dec. 31, 2008. For most taxpayers, it doesn’t make sense to double up on the distribution in one year.

Exceptions to the April 1 RBD include the following:

"Still working" exception: For those who have 401(k)s or other employer plans (not IRAs, SEPs or SIMPLEs), your required beginning date is the same April 1 date as for IRA owners, unless you are still working for the company where you have the plan. If you don’t own more than 5 percent of the company, you can delay your RBD to April 1 of the year following the year you retire. This is sometimes called the "still working" exception to the RBD.
"Old money" exception for 403(b)s: Old money does not mean it is from J. Paul Getty. Rather, it refers to 403(b) plan money contributed before 1987. Required distributions on the balance of your 403(b) plan at Dec. 31, 1986 can be delayed until age 75. You must have a cut-off balance clearly showing the Dec. 31, 1986 balance, which most plans will have readily available, or it may even be on your current statement. The remaining 403(b) account balance (post 1986 money, a.k.a. the "new money") must still follow the regular age 70½ IRA distribution rules.

RMD basics for IRA and plan beneficiaries

Death gets you out of pretty much everything under the tax code, except RMDs. Any RMD not taken by the IRA owner in the year of death is still required and must be taken by the beneficiary. It is not taken by the estate unless the estate is the beneficiary. The beneficiary reports the income on his own tax return. If the IRA owner dies before his RBD, then no distributions are required for the year of death, even if the IRA owner dies in the year he turned age 70½.

IRA and plan beneficiaries are also subject to RMDs and the 50 percent penalty for not taking them. RMDs generally will begin in the year after death of the IRA or plan owner. Non-spouse beneficiaries of plans may be subject to the plan’s own rules which may require withdrawals under the five-year rule or even within the year after death. A beneficiary subject to the five-year rule must completely distribute the account balance by the end of the fifth year following the year of death. A non-spouse plan beneficiary would be stuck with that option unless the plan allows the Pension Protection Act provision (effective in 2007) permitting a direct transfer to an inherited IRA. Roth IRA beneficiaries are also subject to RMDs even though Roth IRA owners are not.

Spouse beneficiary

Spouse beneficiaries may be able to delay required distributions. If the spouse beneficiary chooses to roll the IRA over or treat it as her own, she is subject to the regular IRA distribution rules for IRA owners. If she is 50 years old for example, once she rolls the IRA over, she is not subject to required distributions until she reaches age 70½, even if her husband was already taking required distributions.

If the spouse elects to remain as a beneficiary on a traditional or Roth IRA, then required distributions can be delayed until the later of Dec. 31 of the year the IRA owner would have reached age 70½, or Dec. 31 of the year following the year of the IRA owner’s death.

Proactive RMD planning

For the coming year, advisors should identify all clients and beneficiaries who are subject to RMDs and alert them to this year’s RMD requirements now. Now is the time to find out which clients are subject to RMDs for the coming year and plan out how much must be withdrawn from which accounts. Then create a withdrawal monitoring plan so that all RMDs are taken by year end. This can be accomplished by using my five-point plan for foolproof RMDs.

Identify clients with retirement accounts (including inherited accounts)
This is the first step because this identifies every client who could potentially be subject to RMDs, either as an IRA owner, a plan participant or a beneficiary of any type of IRA or company plan. For many advisors, this list could be the entire client base since most clients do have some type of retirement account. In fact, this exercise would reveal the minority of the clients who have no retirement accounts and that should be looked into. You should know why a client has no retirement account at all, and this may lead to opportunities to create a retirement plan for themselves or their businesses.
Determine which clients are subject to RMDs. Do any exceptions apply?
Identify all clients who are older than age 70½. The odds are pretty good that each of these clients are subject to RMDs, unless an exception applies. Then you would look to see how many of your younger clients are subject to RMDs.

How can someone younger than 70½ be subject to RMDs if the required beginning date is after an IRA owner turns 70½ years old? Easy: Spouse and non-spouse IRA beneficiaries are subject to RMDs at any age.

Advisors should also identify non-individual beneficiaries (such as a trust or an estate) that are subject to RMDs. Since these are entities and not people, advisors need to identify and notify the parties who are responsible for taking RMDs on behalf of these entities. An example would be the trustee of a trust or the executor of an estate.
Calculate RMDs from both IRAs and plans
Once you have identified the clients subject to RMDs, you can help them make the calculations. But the calculations depend on how many and which types of retirement accounts they have. You need to have a complete inventory of all of their retirement accounts so you can identify which accounts are subject to RMDs.

Use the right balance
The required distribution for 2007 is based on the Dec. 31, 2006 balance in the retirement account.

Multiple retirement accounts
If there are multiple IRA accounts, 2007 RMDs are based on the Dec. 31, 2006 balance in all IRAs combined. This balance includes IRAs, SEP-IRAs and SIMPLE IRAs. It does not include IRAs that are inherited or Roth IRAs. The RMD amount can be withdrawn from any one or combination of these IRA accounts.
Create a withdrawal plan
Having a withdrawal plan is crucial. The surest method is the automatic withdrawal. It can be set up monthly, quarterly or once a year, depending on the client’s needs. A once-a-year withdrawal should be timed to come out before Thanksgiving so there is enough time before year-end to address any problems.

As an IRA owner gets older, the distribution should be moved to a point earlier in the year to make sure it is taken care of, especially if the IRA owner is in poor health. It is also a good idea to have a power of attorney in place in case the IRA owner becomes incapacitated. This way, the holder of the power can take the RMD for the incapacitated IRA owner. Careful consideration should be given to the powers granted to the POA holder (i.e., should they be able to change beneficiaries?).
Do a year-end RMD checkup
This should be easy, but is often the key step that is overlooked until it is too late. No later than Thanksgiving, you should check on all of your clients’ distributions from every type of account to see where they are in relation to the total RMD for the year. This checkup would include all your clients set up for automatic withdrawals as systems have been known to skip a distribution now and then. You can then work with your clients who have not totally satisfied their RMD for the year to be sure that any balance remaining is withdrawn. This step alone will eliminate those frantic calls from your client next year when they realize they missed an RMD.

What to do about the 50 percent penalty

This year, don’t let any client miss an RMD. But in the event it happens, take immediate corrective action. Don’t wait for the IRS to discover the error. Make sure the client takes that missed RMD immediately in the current year along with the current year’s distribution.

When the income is reported, Form 5329, "Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts," is to be filed. Include an explanation of why the distribution was missed and ask the IRS to abate the penalty. You no longer have to pay the penalty first and request a refund.

The explanation must show reasonable cause. The important point is that you made up the missed distribution; otherwise, you will not be relieved of the penalty. The IRS will waive the 50 percent penalty for those who make an honest mistake – and even the IRS can consider forgetting an RMD to be an honest mistake.

Ed Slott, CPA, is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books, including Your Complete Retirement Planning Road Map (Ballantine Books; 2007) and Ed Slott’s IRA Advisor, a monthly IRA newsletter. He has also created The IRA Leadership Program™ and Ed Slott’s Elite IRA Advisor Group™, developed specifically to help financial advisors, financial advisor firms and insurance companies become recognized leaders in the IRA marketplace. He is based in Rockville Centre, NY. Visit his Web site at www.irahelp.com.

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