Today’s retirement landscape has evolved so that it is common to see clients working well past age 70½. For these clients, the requirement that they begin taking distributions from their retirement accounts when they hit age 70½ can create a substantial tax burden—in some cases, even bumping the client into a higher tax bracket when the RMD is added to his or her earned income.
Fortunately, there is an exception that can allow these clients to defer their 401(k) RMDs until retirement if certain requirements are satisfied—but it’s important that clients understand the rules, as the exception does not apply to all accounts and penalties for missed RMDs can be daunting.
The “Still Working” 401(k) RMD Rules
While the general rules governing retirement accounts require nearly every individual account owner to begin taking RMDs by April 1 of the year following the year in which he or she turns 70½, an exception exists for employer-sponsored 401(k) accounts owned by employees who continue working past age 70½.
If the plan allows, a client who leaves funds in the 401(k) can avoid RMDs if he or she remains employed with the employer who sponsors the plan (the client can also continue to make contributions to the 401(k)).
Importantly, the current employer must sponsor the 401(k)—a client cannot change employers and defer RMDs beyond age 70½ if a former employer sponsors the relevant 401(k). However, it does not appear that the IRS provides a concrete definition of what it means to continue working past age 70½, so it may be possible for the client to continue working on a reduced-hours basis and still defer his or her RMDs past the traditional required beginning date.
The exception does not apply if the plan is an IRA (whether a traditional, SEP or SIMPLE IRA—RMDs do not apply to Roth IRAs during the original account owner’s lifetime). Additionally, because not all 401(k) plans permit this exception, the client must be careful to ensure that his or her plan actually does allow the funds to remain in the plan to avoid a steep 50 percent penalty that apply to missed RMDs.
If the client has more than one 401(k) and the plans allow for rollovers, it may be possible to roll all 401(k) funds into the 401(k) of a current employer and delay RMDs on all of the funds if the still working exception applies. Combining accounts will also simplify RMD planning once the client stops working, because the RMD on each account would have to be determined separately.
Avoiding the Ownership Trap
While a client may generally avoid taking RMDs from his or her 401(k) as long as he or she continues working past age 70½, many small business owners will not be able to take advantage of this exception. This is because the exception does not apply to clients who are five percent owners of the business sponsoring the retirement plan.
Clients who own a portion of the business sponsoring the 401(k) must also be aware of the constructive ownership rules that apply when determining whether he or she is a five percent owner. Ownership interests held by certain members of the client’s family (i.e., his spouse, children, parents, etc.) and by certain entities in which the client holds a controlling stake will be added to the ownership interest that the client holds directly in determining whether the 5 percent threshold has been crossed.
The “still working” exception to 401(k) can be extremely valuable to older clients who continue to work after RMDs begin, but it’s important that these clients continue to meet all of the exception’s requirements in order to avoid the missed RMD penalty.
Check out previous coverage of RMD planning in Advisor’s Journal.
For in-depth analysis of required distributions from retirement plans, see Advisor’s Main Library.