The rules for calculating required minimum distributions (RMDs) have barely changed in more than a decade, and yet there’s plenty of evidence to suggest that it’s still one of the areas of greatest confusion for clients and advisors alike. That’s not exactly good news. The penalty for failing to take the correct RMD is stiff — 50% of any shortfall — and the wave of baby boomers reaching RMD age has only just begun to crest.
In the coming years, retirement-focused advisors will increasingly find themselves peppered with questions regarding just how much money their clients need to take, from which accounts they must take those funds, and when those distributions must occur. With that in mind, here are three common RMD errors advisors must avoid:
1. Equating “Transfers” With “Direct Rollovers”
An RMD may not be rolled over.
On the surface, that would seem to be a simple rule. In practice, it is one that is often ignored when older (70 ½+) clients move money from a 401(k), or similar account, to an IRA. Here’s why.
How many times have you heard the terms “trustee-to-trustee transfer” and “direct rollover” used interchangeably? Perhaps so much so that you’re thinking “aren’t they the same thing” at this very moment!
Well they’re not. But even those that specialize in this area often blur the lines between the two transactions, largely because they are so similar. After all, trustee-to-trustee transfers and direct rollovers are both ways to move retirement money directly. Both avoid the 60-day rollover window. Both eliminate any concerns regarding the once-per-year rollover rule. And both avoid any mandatory withholding requirements.
Similar? Yes, but not the same. Perhaps the most important difference between the two is that a trustee-to-trustee transfer is not a rollover. Direct rollovers, on the other hand, are rollovers (I mean c’mon, it say’s “rollover” right in the name)! As a result, RMDs cannot be moved in these transactions.
Once you understand this critical difference, it leads to the question… “What makes a transfer a transfer and a direct rollover a direct rollover?” The answer is that a transfer can only take place between similar retirement accounts. For example, if a client is moving money directly from one IRA custodian to another IRA custodian, that’s a transfer. Thus, you can move the total account without regard to whether the client’s RMD has already been taken. Conversely, if your client is moving money directly between different types of retirement accounts, such as from a 401(k) to an IRA, it will generally be a direct rollover. Therefore, before making the rollover, you must first ensure that any RMD has been taken. Only then can the remaining funds be moved to the new institution.
2) “Recalculating” the Life Expectancy of a Non-Spouse Beneficiary
Calculating the RMD for an inherited IRA can be tricky, and to compound the matter, custodians are often of little to no help. Unlike a client’s own IRA, where custodians are required to calculate — or offer to calculate upon request — the RMD, custodians of inherited IRAs have no such requirement. While some custodians still choose to do so, many leave the calculation up to the advisor.
One unique aspect of calculating a non-spouse IRA beneficiary’s RMD is that beneficiaries are not permitted to “recalculate” their life expectancy. This means that you only use a life expectancy table one time — in the year after death — to determine the life expectancy factor (the number by which you divide the prior-year-end balance to arrive at the client’s RMD). Then, in each successive year, you subtract one to arrive at the new life expectancy factor. Consider the following excerpt from the Single Life Table (used by all beneficiaries) to illustrate how recalculating a beneficiary’s life expectancy can lead to mistakes.
Using the table excerpt for reference, let’s suppose you’re working with a client who inherited an IRA last year (2016) and now, in 2017, you’re calculating their first inherited IRA RMD. If we imagine that this client turns 45 this year, then by looking at the Single Life Table, we see that a factor of 38.8 should be used.
Now, let’s fast-forward to next year, 2018. The inclination of many advisors is to return to the table (similar to the way RMDs are calculated during an IRA owner’s lifetime) and calculate the 2018 RMD using a factor of 37.9, but that would be wrong! Instead, the factor used to calculate the RMD should be the 2017 factor of 38.8 less one, or 37.8. The difference here of 0.1 may seem small, but using the wrong factor would result in a shortfall subject to the 50% penalty. Furthermore, continuing to recalculate life expectancy year after year would result in an ever-widening gap between the incorrectly calculated RMD, and the correct amount.
3) Incorrectly Aggregating RMDs
Most advisors know that when a client has more than one IRA, they can generally aggregate, or combine, the RMDs for the various IRA accounts and take the total amount from any combination of those accounts, so long as they take at least the combined total. That same ability to aggregate RMDs does not exist though, when you’re dealing with multiple types of retirement accounts. An IRA RMD, for instance, cannot be taken from a 401(k). The reverse is also true.
But that’s not all. Most of the time, you can’t even aggregate RMDs across the same type of employer-sponsored retirement plans (there’s an exception for 403(b) accounts). For example, if your client has three 401(k) plans, you must calculate the RMD separately for each plan and take at least that amount, separately, from each plan.
You also cannot aggregate RMDs between spouses, nor can you aggregate RMDs between a client’s own retirement account and one they inherit. So when you stop and really think about it, the rule for aggregating RMDs between a client’s own IRAs is actually more the exception than the rule.
Now if you always calculate and take the RMD separately for each of a client’s retirement accounts, you’ll be able to sidestep any RMD aggregation issues. To keep things simple, however, many clients want to take as few distributions as possible, and so for that reason, a sound understanding of the aggregation rules is important.
The following except is from the IRS website and offers a concise explanation of the general aggregation rules that apply to a client’s own retirement accounts.
The list of potential RMD errors is long, but now there are at least three you can confidently avoid!
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