Clients who are 70½ must begin taking annual required minimum distribution (RMD) withdrawals from their retirement accounts, generally by Dec. 31. RMD rules apply to all employer-sponsored retirement plans, 401(k)s, 403(b)s, 457(b)s, traditional IRAs and to IRA-based plans such as SEPs, SARSEPs, SIMPLE IRAs and Roth 401(k)s. RMD rules do not apply to Roth IRAs while the owner is alive, and special rules apply for beneficiaries of IRAs.
If your client fails to withdraw an RMD or its full amount by the deadline, the amount not withdrawn is taxed at 50%. This rule also applies to trusts and estates that were to have received RMDs.
Expect your clients to be surprised. “Most people don't realize there is a penalty. It’s a foreign concept: It’s my money, why are you penalizing me for not spending it?’” says Jim Blankenship, CFP and enrolled agent at Blankenship Financial Planning in New Berlin, Ill. “They’re usually shocked about the rate.”
“I usually get stunned silence, followed by ‘How much?’” says Brian Stoner, a CPA in Burbank, Calif. “Fortunately I only have to discuss it once. They never do it again!”
The penalty may be waived if your client establishes that the RMD shortfall was due to “reasonable error and that reasonable steps are being taken to remedy the shortfall,” according to the IRS.
“The key is to state that the missed RMD, or RMDs if there are multiple years involved, is due to reasonable cause, that the taxpayer has taken reasonable steps to correct the error and is set up for correct RMDs going forward,” says Phyllis Jo Kubey, an enrolled agent and CFP in New York. “Even those that do realize that there is a penalty sometimes wait until the last minute and, by the time they make the request to their IRA custodian and the request is processed, they miss the Dec. 31 deadline. I generally recommend that my clients set up automatic RMDs so there’s less chance of missed distributions.”
To qualify, clients file IRS Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” Your clients also need to attach a letter of explanation addressing in detail why the RMD in question was missed and asserting that operating procedures have been put in place to preclude this oversight from happening again. They should not pay the 50% excise tax up front.
Perhaps because shocked clients rarely repeat such a costly error, tax preparers report success with waivers. Kubey has never had a case where her request for a waiver has not been granted; Stoner is four for four. “If the IRS fails to respond within 36 months, the taxpayer is generally safe in presuming that the penalty has been waived,” says John Dundon, an enrolled agent and president of Taxpayer Advocacy Services in Englewood, Colo.
“Act quickly!” Blankenship adds. “One year is much easier to resolve than three or four years. Take the distribution and request the waiver as soon as possible. And be prepared to pay the penalty: Waivers are not automatic.”
Other good tax moves. RMDs cannot be rolled over into another tax-deferred account, but certain tax-advantaged investments can also help soften the tax blow of RMDs, which are treated as taxable income. Donations to a 529 education savings plan can offer tax breaks on the federal and state level; an individual can contribute up to $14,000 annually without triggering the federal gift tax. Blankenship says one good tax move is a qualified charitable distribution (QCD).
Adds Dundon, “If the taxpayers are married, each spouse can contribute up to $100,000 from their own IRAs.”
QCDs also require a direct transfer from the IRA to the charity. Your client can have the check mailed directly to the charity, or can forward a check from their account payable to the charity. If your client requests a check payable to him or her and intends to contribute the amount to the charity later on, the transaction constitutes a straight RMD.