Unfortunately, more and more retirees miss their distributions each year. Failing to properly withdraw an RMD from an IRA or 401(k) can result in severe consequences including a penalty of 50 percent of the required amount — yikes! If that isn’t enough, the Internal Revenue Service may also pile on interest costs. It is important for retirees or those with retired parents to understand the mechanics of the RMD to ensure that these significant penalties can be avoided.
So why is the IRS imposing such stiff penalties on retirees? The primary benefit of retirement accounts including IRAs and 401(k)s is tax deferral. Unfortunately, the IRS will not allow you to defer taxes in most accounts indefinitely. Since retirement accounts are most often funded with pre-tax dollars and grow for years without any taxes being paid on the earnings, the IRS anxiously waits for retirees to turn age 70½. That’s because at that point, regardless of whether you need the money, you are forced to begin taking distributions. While the IRS does not force you to spend the money, the amount must be withdrawn from the retirement account and the distribution is taxed at ordinary income rates in the year withdrawn.
Determining how much to withdraw can be a difficult process. First, it is important to understand which accounts are affected. Remember, RMDs apply to pre-tax retirement accounts including IRAs, 401(k)s, 403(b)s, etc. If you are still working beyond age 70½, you may not have to take the distribution from your employer plan until you retire.
However, you will still need to take distributions from other traditional IRAs. Since Roth IRAs are funded with after-tax dollars, distributions during your lifetime are not required.
Although RMDs must be taken by Dec. 31 each year, the first RMD does not have to be withdrawn until April 1 of the year after you turn 70½. However, delaying your first RMD until the following year will result in two distributions occurring. For example, let’s assume a retiree turned 70½ during 2013. They have the option of delaying their 2013 RMD until April 1, 2014. However, they will still need to take a 2014 RMD by Dec. 31, 2014, resulting in two distributions for that tax year. This may present a tax planning opportunity as you could choose to defer the RMD depending on other factors including additional income you may be receiving. Remember, this only applies to your first RMD, as all subsequent distributions must occur by Dec. 31.
The RMD amount is determined by dividing the balance of each retirement account on Dec. 31 of the prior year by a life expectancy factor provided by the IRS — see publication 590 for more information. If you have a spouse who is more than 10 years younger and the sole beneficiary, your RMD can be based on your joint life expectancy.
Satisfying your RMD is dependent on whether the account is an IRA or other qualified plan such as a 401(k) or 403(b). First, let’s examine IRAs. While you must calculate the RMD for each IRA separately, you may aggregate your RMD amount and withdraw the total from one IRA. Keep in mind this does not include RMDs for inherited IRAs as they must be calculated and withdrawn separately.
On the other hand, 401(k)s or other qualified plans must be calculated and withdrawn separately from your IRAs or other qualified plans that you might have.
Should you fail to withdraw the minimum required amount, the IRS may assess a penalty of 50 percent of the RMD not taken. For example, if your RMD amount was $15,000 for 2013 and you fail to take the distribution by Dec. 31 of this year, the IRS could impose a $7,500 penalty. Since the IRS receives reports from the custodian of your IRA account providing the balance of your account and any distributions/contributions that occur throughout the year, they are fully prepared to enforce these rules. However, keep in mind that the IRS is not interested on preying on seniors and may waive the 50 percent penalty if you can substantiate that the shortfall in distribution was due to a reasonable error and you have addressed the issue. Consider reviewing IRS form 5329 “Additional Taxes on Qualified Plans” for more information.
With such significant penalties at stake, retirees must follow up to ensure they are taking proper retirement plan distributions from their accounts each year. It may also be a good idea for the children of elderly retirees to confirm that distributions are being properly withdrawn by their parents. Since everyone’s situation is unique, consider speaking to your tax adviser to determine the most appropriate approach for you.
Kurt J. Rossi, MBA, is a certified financial planner practitioner & wealth adviser. He can be reached for questions at (732) 280-7550, kurt.rossi@Independentwm.com or www.Independentwm.com. LPL Financial Member FINRA/SIPC.