As more clients reach age 70 ½, as the first baby-boomer did on January 1, 2016, advisors will be receiving more calls from clients about taking required minimum distributions (RMDs) from IRAs and other retirement accounts. Get it right the first time and avoid these common errors.
1. Not taking all retirement accounts subject to RMDs into account
Clients often have several IRAs or plans. Make sure that they have taken all of those balances into account for calculating RMDs. In addition, they may have inherited IRAs that are subject RMDs.
You need to have a complete inventory of accounts subject to RMDs. There is a 50 percent penalty for not taking an RMD, although the penalty can be waived for good reason by filing Form 5329 with IRS and explaining that the client made an honest mistake, was confused or ill, or received incorrect information from the financial institution or advisor.
The 50 percent penalty also applies to missed RMDs from inherited IRAs and inherited Roth IRAs.
2. Getting confused about first-year RMDs
First-year RMDs are overwhelming for some clients. A common error is using the wrong balance for the first RMD. RMDs begin for the year a client reaches age 70 ½.
Use the December 31st balance of the year before the first required distribution year, even if the actual first RMD is not taken in that year. For the first year, the law gives people until April 1st of the next year to take their first RMD.
For example, if Jim turned 70 ½ at any time in 2015, his required beginning date (RBD) is April 1, 2016. If Jim elects to take his first RMD in March 2016, he still must use the December 31, 2014 IRA balance to calculate his first year RMD, since that is the year-end balance the year before his 70 ½ year (2015).
3. Committing aggregation errors
When clients have multiple IRAs or company plans subject to RMDs, make sure they take their RMDs from the right plan or IRA. For example, you cannot satisfy an IRA RMD from a 401(k), and vice-versa.
However, IRAs have a special aggregation rule that allows RMDs from IRAs (including SEP and SIMPLE IRAs) to be taken from any one or combination of those IRAs. 403(b) plans have the same aggregation rule.
But you cannot satisfy a 403(b) RMD from an IRA and vice versa. You also cannot satisfy an IRA RMD from an inherited IRA.
Inherited IRAs inherited from the same person can be aggregated for calculating RMDs, but RMDs for IRAs inherited from different people cannot be aggregated. They must be calculated and taken separately.
A husband and wife who each have IRAs and are each subject to RMDs must take those RMDs separately from their own IRAs. For example, a husband cannot satisfy his RMD from his wife’s IRA and vice-versa even though the total RMD for both will be reported on the same joint tax return.
4. “Still working” exception mistakes
A special exception to RMDs applies to those who are still working for a company, but this exception never applies to IRAs or to other plans of companies the employee no longer works for. The exception allows employees to delay RMDs until the year after they retire.
It only applies to the RMD from the plan of the company the employee is still working for. This exception also generally does not apply to self-employed clients with a company plan.
That’s because the exception does not apply if the employee owns more than 5 percent of the company and most self-employed clients own much more than 5 percent. They usually own 100 percent or 50 percent or some other large percentage of their business.
The big mistake here is that this exception never applies to IRAs. Sometimes clients think that if the exception applies to them, they don’t have to take RMDs from their IRAs either, and that is not the case. This could subject them to the 50 percent penalty for not taking an RMD.
This so called “still working” exception does not define “still working” so it can apply even if the client worked only part time or for even a few days during the year.
5. Taking RMDs for inherited Roth IRAs
While there are no lifetime RMDs for a client’s own Roth IRAs, inherited Roth IRAs are subject to RMDs and to the 50 percent penalty, even if the RMD would be tax-free, which they generally are.
6. Taking year-of-death RMDs
The confusion here lies in who takes a year-of-death RMD for a client who died and did not take their entire RMD for that year. The beneficiary takes that RMD based on the amount the decedent would have been required to withdraw had he lived.
There is no choice here. The RMD is not reported on the estate income tax return of the decedent (Form 1041) or on the decedent’s final income tax return (Form 1040), as even some CPAs think.
If a client died before his or her RBD, there is no RMD for that year, even if the client turned age 70 ½ that year, but died before April 1st of the following year.
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