Required Mandatory Distributions From Retirement Plans
People born between 1946 to 1963 are classified as Baby Boomers. According to the US census, Boomers constitute a large percentage of the US population and they are retiring in large numbers – approximately 10,000 per day by some estimates. Recent surveys by GoBankingRates have indicated that approximately 1 in 4 persons age 55 or older have over $300,000 in retirement accounts. While many individuals will need to withdraw these balances to fund their retirement, others may wish to retain the funds in their retirement accounts to avoid immediate income taxation. Unfortunately, individuals cannot retain the funds in the accounts indefinitely and there is a day of reckoning when those previous deductions must be withdrawn and taxes paid
In general, the Internal Revenue Code provides that taxpayers who have funds invested in the qualifiedretirement plans and are 70 ½ at December 31 of any given year may be required to make a distribution from their plans. (See Publication 560). The rules for required distributions from Individual Retirement Accounts (IRAs), SIMPLE IRAs and Simplified Employer Pension plans are identical. Internal Revenue Code §401(a)(9)and Treasury Regulations §§ 1.401(a)(9)-1 through 1.401(a)(9)-9 requires that minimum distributions from a traditional IRA, SIMPLE and SEP begin no later than the year the individual’s age is 70½. The rules differ slightly for employer provided defined contribution plans (401k, 403b, 457(B), etc.). For employer provided defined contribution plans, the required distribution is the later of the year the individual’s age is 70 ½ or the year the individual retires from the employer maintaining the plan, even if he or she retires in January of that year.The “required mandatory distribution” date is referred to RMD. Further, the law permits the individual to delay taking the first RMD until April 1st of the year following the year in which he or she turns age 70½. (Note that if the individual does wait until the following year to make his/her initial distribution, he/she must then take a second distribution by December 31st of that same year. As a result, two taxable distributions will occur during the same year.)
The RMD is equal to the value of the fund balance as of December31 of the previous year divided by the individual’s remaining life expectancy. The federal government publishes Uniform Lifetime Tables that governs most lifetime required minimum distributions by prescribing distribution periods depending on the age of the individual and age of the spouse of the individual. (i.e., if the individual’s spouse is greater than ten years younger than the individual, the RMD is lower per the Uniform Lifetime Table.) These tables are contained in Appendix B of Publication 590-B (Distributions from Individual Retirement Arrangements (IRAs))
Moreover, let’s look at an example. Joe holds a retirement plan. He was born on February 1, 1946 and accordingly is age 70½ on August 1, 2016. Although he must begin taking RMDs in 2016, he may defer the disbursement until April 1st of 2017 for the first year.The distribution is based on the account balance on December 31st of the year prior to the year for which the distribution is being taken, i.e., December 31, 2015. Let’s assume Joe’s balance on that date is $300,000. Since Joe’s balance on December 31, 2015 is $300,000 and he will be age 71 in the year for which the initial distribution is taken (February 1, 2017), the minimum amount that needs to be distributed is $300,000 divided by the amount on the table at age 71.Letsassume that’s 26.5. Accordingly, his RMD is $11,320.75 ($300,000 ÷ 26.5 = $11,320.75). Because Joe deferred his initial RMD until his required beginning date (April 1st of the year following the year he became age 70½ or retired), he is required to take a second distribution by December 31st of 2017, based on his IRA account balance on December 31, 2016. If Joe’s account balance has earned interest at 5 percent, the balance in the account on December 31, 2016 would be $315,000, and since he will be age 71 in the year for which this second RMD is taken (2017), the divisor remains 26.5. Accordingly, the balance must be divided by 26.5, producing an RMD of $11,886.79. ($315,000 ÷ 26.5 = $11,886.79). In each subsequent year, Joe must take an RMD at least equal to the account balance on the previous December 31st divided by the table for his age by the end of the distribution year. It should be clear that Joe may certainly take a distribution that is greater than the RMD. He cannot take a distribution that is less than the RMD without incurring tax penalties.
Under §4974(a) and Treas. Reg. § 54.4974-2, the penalty for a failure to take a distribution at least equal to the RMD is 50 percent of the insufficiency. So, if the individual was required to take a minimum distribution of $15,000 and only took $5,000, the failure to take the other $10,000 would result in a tax of $5,000. ($10,000 x 50% = $5,000). The tax would be calculated and remitted via Form 5329 (Additional Taxes on Qualified Plans).
Not only are distributions required during a retirement plan owner’s lifetime, they are also required at his or her death. The rules governing required distributions at death vary, however, depending on whether the plan owner died before or after the RMD beginning date. The RMD beginning date for plans described above is April 1st of the year following the year in which the owner became or would have become age 70½ (or at retirement as described above for defined contribution plans).
If a plan owner’s death occurs before the beginning date, distributions must normally be made pursuant to the Life expectancy rule orFive-year rule. If a plan beneficiary elects to receive a distribution under the life expectancy rule, the interest in the plan must be distributed over the beneficiary’s life or life expectancy and must start no later than the end of the calendar year immediately following the year of the plan owner’s death. (The life expectancy distribution rules are changed somewhat when the beneficiary is a surviving spouse as described below). In a plan distribution taken under the five-year rule, a beneficiary’s interest must be completely distributed within five years following the plan owner’s death.
A surviving spouse beneficiary has other options. He or she may choose to treat the deceased owner’s plan as his or her own. However, if the surviving spouse does not choose to treat the plan as his or her own and chooses, instead, to take distributions over life expectancy, such distributions must begin by the later of the end of the calendar year, immediately following the calendar year in which the plan owner died or the year in which the owner would have reached age 70½.
A surviving spouse may also elect to treat the retirement plan as his or her own and be considered the retirement plan owner. In order to make such an election, the surviving spouse must be the sole beneficiary and must have an unlimited right to make withdrawals. If the spouse is eligible for and makes the surviving spouse’s election, withdrawals made by the spouse before the spouse’s age 59½ would be subject to a premature distribution tax penalty. Furthermore, RMDs from the retirement plan must begin no later than April 1st of the year following the year the surviving spouse reaches age 70½. Note that if a plan owner’s death occurs on or after the RMD date but before the entire plan interest has been distributed, the balance of the plan must be distributed at least as quickly as under the method of distribution in effect at the time of the plan owner’s death.
Due to the complexity of the retirement plan rules and the options available regarding distributions from retirement accounts, any individual with significant balances in their retirement plans should consult their tax advisors as they approach age 70. By analyzing the RMD rules in relation to their other income sources, an individual and their tax advisors can appropriately determine a plan of distributions that will minimize their taxes and avoid the harsh penalties for failing to make the necessary distributions.
