Required Minimum Distributions (RMDs) are the minimum amounts you must withdraw from retirement accounts each year1. There’s some complexity in the RMD rules, there have been significant changes to these rules in recent years and there may be more in the future.
The strategies addressing how to access funds in a retirement account, when to access these funds and how much to withdraw is a very significant part of retirement planning. Recommended RMD and retirement account distribution strategies, in general, involve a big picture examination of your entire financial picture. Unfortunately, like many financial strategies, retirement account distribution planning is not simply a “set it and forget it” exercise. It is so much more. It often requires a cross-disciplinary and multi-generational approach considering investing, taxes, philanthropic and estate planning issues among others.
I believe it is important to define two terms before continuing further. Retirement plans generally are either Defined Benefit (DB) plans or Defined Contribution (DC) plans. A DB plan promises a specified monthly benefit at retirement. These are the traditional pension plans generally funded by the employer. A DC plan does not promise such a retirement benefit. A DC plan is essentially an account funded by the employee, sometimes with contributions by the employer. The value of this account many fluctuate with changes in the values of the investments. DC plans include IRAs, 401(k)s, 403(b)s and profit-sharing plans, among others8.
Over the years, the Family Wealth Decisions Group has observed many RMD and retirement account withdrawal decisions which could have turned out better…and probably should have turned out better. We are limiting this discussion to only five retirement account withdrawal mistakes in areas we consider to be foundational.
Mistake #1: Taking it all at once.
IRA beneficiaries and the beneficiaries of most retirement plans have an option of taking a lump sum distribution. To the extent that such a distribution represents taxable income to the beneficiary, income tax may be due and owing2. In many cases the option of accessing the entire value (or even a significant portion) of a retirement account at once, especially one designed to be paid out over time, is irresistible. However, just because you can do something, doesn’t necessarily mean you should.
Retirement accounts are afforded a certain amount of creditor protection under ERISA (Employment Retirement Security Act) for ERISA qualified plans (such as employer sponsored defined benefit pension plans, 401(k) plans and some other defined contribution plans)3. IRAs are not protected under ERISA but may have some federal protection from bankruptcy under the Bankruptcy Abuse and Consumer Protection Act. You would have to look to state law for additional creditor protection for IRAs3. You may lose these protections for funds you withdraw from these protected environments.
Funds distributed from tax-deferred accounts may also be subject to income tax as the distributions will be includible in taxable income4. Due to the progressive nature of the federal income tax brackets, increasing the amount of taxable income increases the tax rate,5 further increasing the tax bill on larger distributions. In addition, in many cases early distribution (before age 59½) from tax-deferred accounts may be subject to a non-tax-deductible penalty4. Therefore, tax considerations could be an additional reason to avoid unnecessary large lump sum distributions.
Finally, accessing retirement account values as soon as they become available, leaving the retirement account creditor protection behind and diminished in value by a tax bill, can increase the chance that the retirement account will be exhausted sooner than anticipated. Exacerbating stress on the longevity of these accessed funds is the fact that the purchasing power of each dollar accessed may decline over time due to inflation.
There may be a good reason for cashing out of a DB pension plan if you are concerned about your employer’s financial condition. However, the PBGC (Pension Benefit Guaranty Corporation) can provide some protection for at least some lost pension benefits6. The decision to access the account values when you are able to do so is a potentially irrevocable and life-changing decision. In the case of pension plans, there is often not a lot of time to decide whether to take a lump sum or a payout arrangement6. A decision whether or not to take a lump sum or make a very significant tax-deferred account withdrawal clearly is one that could benefit from consultation with an expert financial advisor.
Mistake #2: Missing the deadlines to start RMDs.
Required minimum distributions allow the potential income tax bite embedded in a tax-deferred retirement account to be spread out over a period of years or a life expectancy. However, if you wait too long to begin these required distributions, you may face a potential 25% additional excise tax on the amount of the required distribution not distributed7.
With the passage of the Secure Act and Secure Act 2.0, the deadlines for taking required minimum distributions have been moving targets as the deadlines for taking the distributions have changed and are scheduled to change some more. Consequently, not starting RMDs on time may be a common mistake. Currently,
- The first RMD from a tax-deferred IRA must occur by April 1 of the year after the year your turn 737;
- The first RMD from other DC plans must occur by the later of April 1 of the year after the year your turn 73 or by April 1 of the year after the year in which you retire – if the plan so permits7.
- Most DB plan benefits begin paying out at one of the following dates: (1) the plan’s early retirement date, (2) the plan’s normal retirement date, or (3) the actual retirement date where it occurs after the normal retirement date9.
- The starting age of 73 applies to those born between 1951 and 1959. If you were born later than 1959, the RMD beginning date is age 75. However, this may change over the next 10 years11.
What happens if you miss the deadline or miss making an RMD? You could suffer a penalty of up to 25% of the amount not withdrawn. Note, the penalty used to be 50% but it was reduced by Secure Act 2.0. It may even be lower (10%) if you cure the shortfall within two years. Ed Slott also opines on some potential statute of limitations risk confusion after Secure Act 2.0 – is it 3 years or 6 years10?
Mistake #3: Incorrectly calculating the RMD and its taxation.
Although often a relatively simple arithmetic task, there may be some complexities. In general, an RMD is calculated for each account by dividing the prior 12/31 account value by a factor on tables published by the IRS in publication 590-B. There are three basic tables that can be used1. The first issue is choosing the correct table.
· Single Life Expectancy -Table I for inherited IRA account holders;
· Joint and Last Survivor - Table II where the surviving spouse who is more than 10 years younger than the decedent and is the sole survivor; and
· Uniform Lifetime - Table III where the spouse is not the sole beneficiary or not more than 10 years younger than the decedent.
This is the simple part. It can get more complicated where a plan received pre-1987 amounts1. Annuities can complicate matters as well. For annuities, the prior year’s 12/31 market value may not be the same as the 12/31 account value due to the presence of living benefit and/or death benefit riders12.
The IRS has information about each account subject to RMD as the account custodian or trustee files form 5498 with these details13. Although the custodian or plan administrator may calculate the RMD, it is ultimately the account owner’s responsibility for making the correct distributions1.
If you have miscalculated your RMD or missed the payment altogether, you basically have two choices: pay the penalty or apply for a waiver. Form 5329 can accompany your check for the correctly calculated RMD plus any penalty. Form 5329 can also accompany your letter of explanation of reasonable error requesting a waiver of the penalty14.
More complexity exists when considering the taxation of distributions. Again, in general, to the extent distributions are from tax deferred accounts, they will potentially be taxable income. Tax deferred accounts have been funded with pre-tax contributions from income – tax has not yet been paid on this income. What about IRA accounts which have been funded with after-tax contributions? What about Roth IRA distributions? To the extent the distribution is a return of basis or from a Roth, it is tax free1.
For those who make after-tax non-deductible contributions to and distributions from a traditional IRA, a form 8606 should be filed each year contributions and distributions are made15. Failing to file Form 8606 to report a nondeductible contribution may be subject to a $50 penalty ($100 if the deduction is overstated) waivable with a showing of good cause15. It is important to keep all copies of Form 8606 filed to keep track of the non-deductible contributions made to help prorate taxation of distributions. Without accurate and complete records of after tax funds contributed to a nondeductible IRA, you might pay tax twice on the same money. This paper trail can be especially helpful where a non-deductible IRA is inherited. It gets a little more complex when you realize that to perform the pro-rating calculation to determine what part of a distribution is a tax-free return of basis, all IRA balances (traditional, SIMPLE and SEP) are aggregated15.
Mistake #4: Not knowing the different rules for different accounts.
The RMD rules apply to account owners and their beneficiaries in many types of accountsin addition to IRAs including 401(k) plans, 403(b) plans, 457(b) plans, profit sharing plans and other kinds of defined contribution plans7. We discussed above how defined benefit pension plans have their own distribution rules.
When considering the discussion about deadlines to begin distributions, we stated there are different deadlines for different types of accounts. For example, account beneficiaries have their own set of rules. Their RMD requirements depend on the following major factors2:
- Whether the account owner died before or after the Secure Act was passed (2019) as significant RMD changes were part of that law;
- The relationship of the beneficiary with the account owner and certain characteristics of the beneficiary for those deaths after the Secure Act;
- Whether the original account owner died before or after their Required Beginning Date (RBD) – the date the original account owner was required to begin taking RMDs,
When the account holder dies before 2020 and before their RBD, a spouse beneficiary has the option to roll the account into their own IRA or to keep the account as an inherited IRA and take distributions over their life expectancy or to fully exhaust the account within 5 years (the 5 year rule)2. Where the original account owner died after their RBD, the spouse beneficiary may take distributions based on their own life expectancy2.
When the account holder dies after 2019 and before their RBD, a spouse beneficiary has the option to roll the account into their own IRA. In the alternative, the spouse beneficiary may delay distributions until the decedent account owner would have turned 72 or take distributions based on their own life expectancy or exhaust the account within 10 years (ther10 year rule)2. Where the original account owner died after their RBD, the spouse beneficiary may take distributions based on their own life expectancy or roll the account into their own IRA2.
Where the account owner died before 2020 and before the RBD, the non-spousal beneficiary’s options are to follow the 5 year rule or take distributions based on their own life expectancy. Where the account owner’s death occurred after the RBD, the beneficiary could stretch distributions out over the longer of their own life expectancy or the account owner’s remaining life expectancy2.
Especially for non-spousal beneficiaries where the account owner dies after 2019, it can get even more complicated. The Secure Act created a 10 year rule (requiring exhausting the account within 10 years) for non-spousal beneficiaries. It also defined a class of eligible designated beneficiaries where the 10 year rule may not apply. These eligible beneficiaries include: spouse or minor child of the account holder, disabled or chronically ill individual and an individual not more than 10 years younger than the account holder2.
Although Roth IRAs are not subject to RMDs by the account holder, inherited Roths must follow the IRA RMD requirements even though they may not be subject to tax2.
Mistake #5: Not planning with the big picture in mind.
Lack of planning coordination is an error we see with nearly every type of financial decision-making and planning. Often decisions about tax strategies, retirement strategies, estate strategies, insurance policies and investing are made in individual silos – in isolation of other financial decisions. These financial decisions may be made with different advisors at different points in time for different purposes. As a result, sometimes progressing toward the overarching financial objectives may become subjugated to completing an isolated transaction which may not be well-coordinated with those goals.
Adding to this complexity are dilemmas between apparent conflicting choices which may arise. For example, maximizing income tax benefits for the current retirement account owners by continuing tax deferral as long as possible, even until death, may create a larger income tax problem, possibly in addition to an estate tax issue for those beneficiaries inheriting. A lack of coordination among these decisions may obscure the big picture and create planning gaps through which wealth may be lost or which may cause goals not to be fully met.
Have you considered charitable distributions to avoid tax on all or part of an RMD? Have you consolidated your retirement accounts to potentially reduce fees and simplify the RMD calculation and distribution process? Have you considered the use of trusts as retirement plan beneficiaries where asset protection is important? Have you determined whether any special needs persons receiving government benefits might be negatively impacted if they are a beneficiary or contingent beneficiary? Have you considered the potential benefits of Roth conversions? Have you coordinated your retirement account beneficiary designations with the beneficiary designations in your will and trusts, in insurance policies and bank and investment accounts? Does your big picture asset flow meet with your satisfaction?
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We consider the five mistakes addressed above to be foundational in dealing with RMDs and retirement account distribution planning in general. However, we have seen many others – some big and some small. Why do these mistakes occur? Sometimes decisions may be made emotionally, compulsively or rashly. Sometimes decisions may be made in the absence of good information or based on misinformation. Sometimes decisions may be made carelessly without consideration of the potential consequences in the mistaken belief that the decisions are not important.
Good planning decisions should be made not only considering their immediate consequences, but also those that may derive from them. Effective retirement planning decisions are not made in a vacuum, isolated from all other planning decisions, but rather should be made in coordination with them. This is where an experienced credentialed advisor can be of assistance and value.
Whether you need to create a retirement distribution plan now, update an existing plan or merely review your planning, a conversation with an advisor can be beneficial. Often mistakes, once discovered, can be reversed, repaired or overcome. Sometimes they cannot be corrected or ameliorated. The topic of retirement plan distributions can become very complicated and different decisions can have significant impact on retirement lifestyle and taxes.
That the topic is so complicated with rapidly changing rules to be followed by senior citizens who, in general, may be experiencing declining cognition, seems a little paradoxical. This is why we offer a complimentary consultation to discuss these and other financial decisions you may need to make. Contact us to arrange your consultation.
1. https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs
2. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
3. https://www.dominion.com/asset-protection/are-iras-protected-from-creditors
4. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-distributions-withdrawals
8. https://www.dol.gov/general/topic/retirement/typesofplans
9. https://irahelp.com/slottreport/how-do-rmds-work-db-plans/
10. https://www.morningstar.com/retirement/new-rules-missed-rmds
12. https://www.massmutualascend.com/insights/your-guide-to-required-minimum-distributions
13. https://www.irs.gov/pub/irs-pdf/f5498.pdf
14. https://smartasset.com/retirement/if-you-miss-your-rmd-deadline
15. https://www.irs.gov/pub/irs-pdf/i8606.pdf