Required minimum distributions are usually due by the end of the year, so why bring them up now? Isn’t it best to take them late in the year to maximize the tax-deferred buildup for as long as possible?
In theory that sounds right, but there are practical advantages to taking the RMD earlier in the year.
Easing RMD stress: Taking RMDs earlier in the year puts less pressure on the beneficiaries if the client dies before taking the distribution. We often see problems in the year of death, especially when beneficiaries have a tight window to take the year-of-death RMD.
When an IRA owner subject to RMDs dies before taking the distribution for the year, it must be taken by the beneficiary. The beneficiary takes the RMD amount that the deceased IRA owner would have had to take had he lived. There is sometimes not enough time to get this done when an IRA owner dies late in the year.
For example, if the client dies in December without having yet taken the RMD for the year, an inherited IRA generally needs to be set up and the beneficiaries must take the RMD (each taking their share) by year-end. That’s unlikely to be done.
First, before an inherited IRA can be set up, a death certificate must be presented to the IRA custodian. That may take some time depending on the circumstances and who the beneficiaries are. If the IRA beneficiary is a trust for instance, that might add a layer of complexity and delays. Or if the beneficiaries reside in different states, paperwork may take longer even with scanning and email. Sometimes beneficiaries are hesitant to take action without consulting advisors on their own behalf, especially if there are issues among the siblings or other beneficiaries, for example with step-children of blended families and second marriage situations. These things cause delays.
If you have these situations, it’s a good idea to review all IRA and plan beneficiary forms now to avoid disputes and ambiguity after death. A beneficiary form review and update is a simple, but high-value service that advisors can provide.
Setting up inherited IRAs also means making direct transfers. Inherited IRAs can only be funded via a trustee-to-trustee transfer from a decedent’s account. These transfers tend to be more time consuming, adding to delays. A non-spouse IRA beneficiary can never do a 60-day rollover.
In addition, taking an RMD for a deceased parent a few weeks after death is not usually first on anyone’s to-do list. Of course there are remedies for a missed RMD, but this requires more time and work for your client, the tax preparer and the beneficiaries.
Waiving the 50% penalty: Once there is a missed RMD, the 50% penalty becomes an issue that must be dealt with.
First, the missed RMD must be made up by the beneficiaries as soon as possible. The year-of-death RMD is not taken by the estate. That means the beneficiaries must each file IRS Form 5329 [Additional Taxes on Qualified Plans (including IRAs) and Other Tax Favored Accounts] for the year of death, requesting that the penalty be waived due to the death of the taxpayer, and stating that the missed year-of-death RMD was taken by the beneficiaries.
That form must be filed or the 50% penalty will never be removed. The penalty will continue looming as a liability. IRS and the U.S. Tax Court consider Form 5329 a separate stand-alone tax form since it has its own signature line. If the form is not filed, the statute of limitations never begins to run and the beneficiary(s) will have an open liability to the IRS.
But this entire correction scenario can be avoided by taking RMDs earlier in the year. Even if a client dies later that year, there will be no year-of-death RMD issue, since it was already taken. If the client dies early in the year before it was taken, there will still be time for beneficiaries to deal with the year-of-death RMD.
First dollars out RMD rule: Once a client is subject to RMDs, the law states that the first dollars of the year withdrawn from the IRA (or plan) are deemed to satisfy the RMD. If the client does not want to take the RMD until later in the year, other withdrawals must be put on hold until that RMD is satisfied.
For example, if a person is subject to RMDs but wants to do a rollover within the year, they cannot do that until the RMD is withdrawn. If the client wants to do a Roth conversion, it cannot be done until the RMD amount is satisfied. RMDs cannot be converted to Roth IRAs because they are considered rollovers and RMDs are not eligible to be rolled over. Once the RMD is taken though, all other IRA funds are available to be rolled over or converted.
Clients, and even advisors, can often unknowingly violate this “first dollars out” rule when doing a Roth conversion. Why? Because the funds withdrawn and converted to a Roth IRA are taxable, so in the client’s mind they paid tax on the funds coming out of their IRA and that’s the same outcome as if they withdrew the RMD and didn’t convert the funds.
Here’s an example: John has a traditional IRA with an RMD of $15,000. He converts $100,000 from the IRA to a Roth IRA, thinking that the first $15,000 withdrawn satisfies his RMD for the year. It doesn’t. What has happened is that John still owes tax on the full $100,000 since that was withdrawn from his taxable IRA funds. But only $85,000 was eligible to be converted, since the first $15,000 was deemed to be his RMD and that amount cannot be converted or rolled over.
That $15,000 is now an excess Roth IRA contribution and must be removed by October 15th of the year following the year of the excess contribution (along with any income or loss attributable to that $15,000). If that excess is not timely removed, then there will be a 6% penalty assessed for each year the $15,000 excess remains in the Roth IRA. The 6% penalty is also reported on Form 5329 which must be filed, otherwise the liability continues.
If the RMD were taken earlier in the year, that would avoid this tax problem because then the entire remaining IRA balance would be eligible to be converted.
Plan an IRA rollover with caution: RMDs can also present a problem in a 401(k) when your client is subject to RMDs but wants to roll their 401(k) balance to an IRA you set up for them. The RMD must first be withdrawn from the plan before any of the remaining plan funds can be rolled over to an IRA. If the RMD is taken earlier in the year, this will not be a problem because all the remaining funds in the plan would be eligible to be rolled over.
Sometimes in a rush to get the 401(k)-to-IRA rollover done, the entire plan balance is rolled over, including the RMD. Again, that creates an excess contribution to the IRA which must be removed. Once again, taking the RMD earlier in the year, removes this potential problem.
Yes, on the surface it seems that delaying RMDs leaves more IRA income sheltered from taxes, but taking the RMD earlier in the year can eliminate a domino effect of other expensive tax problems that take time and effort to correct.
No client wants tax problems or wants them for their beneficiaries. Connect with your clients now to review the best plan for taking annual RMDs.