How to Avoid the 50% Required Minimum Distribution Penalty

Calculating RMDs

An IRA owner and a qualified plan participant cannot keep funds in a retirement account forever. The IRS requires that distributions be taken. Why? Because they want to tax the income which they have allowed the IRA owner and qualified plan participant to defer for many years. The IRS prescribes how much they force the IRA owner and plan participant to take. How does the IRS enforce the distribution requirement? By levying a 50% penalty on the amount that was less than the Required Minimum Distribution (RMD). Let’s take a peak at the basics.

Your Required Beginning Date (RBD)

The date you must first begin RMDs is generally no later than April 1st of the year following the year you turn age 70 ½. For example, if you turn 70 ½ at any time during 2008, you must take your first RMD no later than April 1, 2009. If your retirement funds are in a company 401(k) plan, a 403(b) plan or other qualified retirement plan, your RBD is still April 1st of the year following the year you turn 70 ½, with one exception. If you are still working for the company and you do not own more than 5% of the company, you may delay your RMD until April 1st of the year following the year of your firnal retirement. This exception does not apply to IRAs.

There is a special exception for 403(b) plans in which you participated prior to 1987, you may delay RMDs on that plan only and only to plan balances as of December 31, 1986.

ROTH IRA fund balances are exempted from the requirement to take RMDs if they originate with the IRA owner. IRA owners of inherited ROTH IRAs are required to take RMDs.

How is The Required Minimum Distribution Computed

There is an easy five-step procedure to this process to make sure you have the right RMD amount. It’s OK to let a financial institution or advisor compute this for you, but it’s a good idea to be able to check the computation. Here’s how.

Step 1:  Determine the first distribution year. The first distribution year is the year the IRA owner or qualified plan participant turns 70 ½.

Step 2:  Determine the IRA balance(s) or qualified plan balance(s) at the beginning of the first distribution year, which is the year the IRA owner or qualified plan participant turns 70 ½. All IRA balances (not ROTH IRA balances) must be added and all qualified plan balances must be added, to arrive at two separate totals. Both IRAs and qualified plans must satisfy the RMD requirements.

Step 3:  Determine the life expectancy factor from the Uniform Lifetime Table based on the age of the IRA owner or plan participant at December 31 of the first distribution year. For example: the life expectancy factor (in years) for a person age 70 on December 31, 2008 is 27.4. Note: The Uniform Lifetime Table is not used for inherited IRAs. The Single Lifetime Table is the one used for inherited IRAs.

Step 4:  Divide the IRA balances by the life expectancy factor and divide the qualified plan balances by the same life expectancy factor to get two RMDs.

Step 5:  Pay the RMDs for both IRAs and qualified plans. If it is the first RMD, it must be taken no later than April 1st of the year after the first distribution year. If it is the second or later RMD, it must be distributed by December 31.

RMDs may be taken on or before December 31 of the distribution year. It can be a good tax strategy to take the first RMD in the first distribution year. Otherwise, the year after the first distribution winds up with two distributions: the one due by April 1st and the second one due on or before December 31 of the second distribution year.

Other Special Rules and Considerations

Before converting a traditional IRA to a ROTH IRA, the RMD for that year must be taken. Then the balance left can be converted to the ROTH IRA.

The current year RMD is always computed using the IRA or qualified plan balance at the end of the previous year. There is not adjustment for a decline in value due to market volatility.

There is no limit on the amount of annual distribution. Amounts greater than the RMD can be taken.

Financial institutions report IRA balances to the IRS on Form 5498 annually. The form has a box, Box 11, that says “Check if RMD for xxxx year.” The financial institution knows your birthday. If that box is checked, the IRS tracks these and will know when RMDs are required.

ROTH IRAs inherited by nonspouse beneficiaries are subject to RMDs. It would be true folly to have to pay the 50% penalty on an otherwise nontaxable distribution.