The rules regarding required minimum distributions (RMDs) from retirement accounts—both IRAs and qualified plans—vary. For clients who have reached the age when they need to start taking retirement income, this can be very confusing. To help you bring some clarity to your conversations with clients, I’ve created this RMD guide for financial advisors that highlights answers to questions, common scenarios, and errors to avoid.
When Do Clients Start Taking RMDs?
As you are no doubt aware, distributions from 401(k) plans and IRAs are required starting the year in which an individual turns 70½, otherwise known as the required beginning date (RBD). Additionally, a client must pay income tax on each withdrawal.
An individual’s first RMD can be deferred until April 1 of the year following the year that he or she turns 70½. For all subsequent years, RMDs for the current year are due by December 31 of that year.
Deferring a first-year RMD. Retirees who defer their first RMD will need to take two distributions in the same year: one RMD will be due for the year delayed and another will be due for the current year. The December 31 value for the current-year RMD will not be reduced by the amount that the client has deferred. Both RMDs will be taxed as income for the year in which the RMDs are taken. Two such withdrawals could significantly increase a client’s income tax bill for that year.
Example: Jane turned 70½ in 2013. She is required to take an RMD for 2013, based on the December 31, 2012, year-end value of her account. Because 2013 is Jane’s first RMD year, she defers taking the RMD until April 1, 2014. She must also take her 2014 RMD by December 31, 2014, based on the 2013 year-end value of her account.
Deferring her RMD for 2013 does not reduce the 2013 year-end value of her account on which her 2014 RMD will be based. Both RMDs must be taken in full in 2014 based on the appropriate year-end values, and both RMDs in this case will be taxable to Jane in 2014.
Best practice: Before deferring an RMD, clients should look at their tax situation and consult their tax advisor to determine whether or not two RMDs in the same year will force them into a higher tax bracket.
What If My Client Misses an RMD?
The tax penalty for failing to take an RMD, or failing to take a large enough distribution, is 50 percent of the RMD amount not taken. Your client will also have to pay regular income tax on the amount that should have been withdrawn
Best practice: IRA owners who forget to take their RMDs should take them immediately. If the IRA owner believes that the missed RMD was due to a reasonable error, and if he or she has taken or is taking steps to remedy the missed distribution, the owner can request a tax waiver by completing IRS Form 5329 and attaching a statement of explanation
What About Roth Accounts?
Roth conversions. RMDs are not eligible for conversions to Roth IRAs. If a traditional IRA owner is at least 70½, his or her RMD for that year must be taken prior to a Roth conversion. But because RMDs are not required for Roth IRAs, once the RMD has been taken from a traditional IRA and a Roth conversion is complete, the Roth IRA money will not be subject to RMDs going forward
Keep in mind that completing a Roth conversion is a taxable event, and taxes on Roth IRA contributions have already been paid, so that money can be withdrawn as needed tax free
Roth 401(k) and 403(b) plans. Although RMDs are not required for Roth IRAs, they are required for Roth 401(k) and Roth 403(b) plans, even though taxes have already been paid on the deposits.
Because the money for these plans is post-tax, however, RMDs will not increase a client’s taxable income (as a traditional IRA RMD would). If, however, your client misses an RMD, he or she will incur a 50-percent penalty
Keep in mind that, if a client chooses to roll over 401(k) or 403(b) funds after turning 70½ and an RMD is due, the RMD portion of the account balance is ineligible for the rollover. Therefore, the RMD must be satisfied before rolling over the funds into a Roth IRA.
Best practice: A client might want to consult a tax advisor to determine whether it would be beneficial to roll a 401(k) or 403(b) plan into a Roth IRA before the client’s RBD.
Can Clients Delay Qualified Plan RMDs?
People who are still working after age 70½ can delay distributions from their current 401(k), but not from their IRA, until April 1 of the year after they retire. This is great for employees still working at age 70½ because they can leave that money in the plan, thus reducing their drawdown rate until they retire.
IRS rules state that, for 401(k), profit-sharing, 403(b), and other defined-contribution plans, individuals must begin taking RMDs by April 1 of the year following the year they turn 70½ or the year they retire (if allowed by the plan), whichever is later. If, however, an individual owns 5 percent or more of the business sponsoring the plan, he or she must begin receiving distributions by April 1 of the year after the calendar year in which he or she reaches age 70½.
Although clients can delay RMDs from their 401(k)s if they are still working, this IRS rule does not apply to SEP- and SIMPLE IRA plans. With these plans, clients can continue to make contributions if they are still working at age 70½, but they must take RMDs.
Best practice: Review the terms and conditions that govern your clients’ qualified plans to understand the rules for taking RMDs, as they can vary. The terms that govern one qualified plan may allow clients to wait until the year they actually retire to take their first RMD (unless they are a 5-percent owner), while those of another plan may require clients to begin taking distributions by April 1 of the year after they reach age 70½, even if they have not retired.
Employers must continue making plan contributions for employees even if the employees have turned 70½ and are taking RMDs. The employer must also give an employee the option to continue making salary deferrals as long as the employee is eligible to participate in the plan. If the employer does not adhere to this requirement, the plan can lose its qualified status.
If a plan does fail to meet this requirement, the situation can be corrected through the Employee Plans Compliance Resolution System, available in the Correcting Plan Errors section of the IRS website.
When Can RMDs Be Aggregated?
RMDs from certain types of retirement plans have different rules that determine which RMDs can be aggregated and which ones cannot.
For IRAs (i.e., SEP-, SIMPLE, and traditional), RMDs may be aggregated. Although the IRA owner must calculate the RMD separately for each IRA owned, if he or she has multiple traditional, SEP-, or SIMPLE IRAs that require an RMD, he or she may take a distribution from one of them to satisfy the total RMD amount for all of them.
For 401(k), profit-sharing, and 457(b) plans, RMDs must be taken separately. This means that, if an individual has a 401(k), profit-sharing plan, and traditional IRA, he or she is required to take a separate RMD from each plan. These RMDs may not be aggregated with other RMDs from nonqualified plans or each other.
- If a client rolls over these plan amounts into an IRA before his or her RBD, the RMD rules for IRAs apply.
- If the individual chooses to roll over the funds after turning 70½ and an RMD is due, the RMD portion of the account balance is ineligible for the rollover [embed link to Key IRA Rollover Considerations article] and must be satisfied separately before the funds are rolled over into an IRA.
For 403(b) plans, RMDs may be aggregated. Like an IRA owner, a 403(b) plan owner must calculate the RMD separately for each 403(b) plan owned but can take the total amount from one or more of the 403(b) plans to satisfy the entire RMD plan amount. A 403(b) plan owner cannot, however, take an RMD from a 403(b) plan to satisfy one from an IRA or an RMD from an IRA to satisfy one from a 403(b). Additionally, 403(b) plan RMDs cannot be aggregated with 401(k), profit-sharing, or 457(b) plans.
The various situations regarding RMDs can be complex and confusing, so understanding the rules and tax implications is crucial. In particular, clients should consult their tax advisors for advice on the implications of deferring their first-year RMDs.
You’ll find a host of helpful resources at IRS.gov, including:
- Retirement Plans FAQs regarding RMDs
- Retirement Topics: Required Minimum Distributions (RMDs)
- RMD Comparison Chart (IRAs Vs. Defined- Contribution Plans)
- Publication 590
- Publication 560 for Retirement Plans
- Publication 571 Tax-Sheltered Annuity Plans (403(b) Plans
Are your clients concerned about how required minimum distributions fit into their retirement plan? Be sure to comment below if you have any other questions that you’d like me to address.