Identifying and preventing retirement distribution planning mistakes

Individual retirement accounts (IRAs) and qualified plans (QPs), such as 401(k) plans, often make up a significant portion of an individual’s assets. These accounts are subject to numerous and often complicated rules. Understanding these rules goes a long way in preventing some of the most common mistakes made with regard to retirement distribution planning.

Failure to take a required minimum distribution and the 50 percent excess accumulation penalty

IRAs and QPs are tax-favored accounts in that the income and growth on the assets in the accounts are allowed to accumulate on a tax-deferred basis and are not taxed until distributed to the account beneficiary. Congress intended these accounts to be true retirement accounts (i.e., used by the account owner in retirement) and not wealth transfer vehicles. As such, Congress requires distributions to be made from these accounts to the account owner generally beginning when the account owner reaches age 70 ½. The first distribution needs to be made by April 1t of the calendar year following the year the owner turns age 70 ½. This is known as the required beginning date. Going forward, a distribution must be made by December 31t of each calendar year thereafter to the account owner. Failure to take these mandatory distributions, which are known as required minimum distributions (RMDs), will result in a 50 percent excess accumulation penalty being assessed to the account owner/taxpayer on the shortfall, the amount that was required to be distributed but was not.

For example, assume Mark owned an IRA and was over age 70 ½. Assume further that he was required to take an RMD of $100,000 in 2014, but that no distributions were taken during 2014. His shortfall, the amount that was required to be distributed but was not, is $100,000. Therefore, he would be subject to a $50,000 excess accumulation penalty for failing to take his 2014 RMD (i.e., $100,000 shortfall x 50 percent penalty).

The 50 percent excess accumulation penalty is one of the steepest penalties the IRS imposes with regard to retirement accounts. Thankfully, it is also one of the easiest to avoid. We recommend that taxpayers nearing age 70 ½ and those who have already started taking RMDs from their retirement accounts should consult with their advisors to ensure that they are taking RMDs when required and that the distributions taken are sufficient.

The 50 percent excess accumulation penalty applies not only to IRA and QP account owners; it also applies to inherited IRA and QP beneficiaries. Inherited account beneficiaries who receive an account due to the death of an account owner, are required to start taking distributions from the account by December 31t of the year following the year of the account owners death. If these RMDs are not taken, the same 50 percent excess accumulation penalty applies. Therefore, we also recommend that individuals who inherit a retirement account should also consult with their advisors to make sure they are adhering to the required minimum distribution rules.

As with many other penalties, the IRS provides a mechanism for a waiver of the excess accumulation penalty. If the taxpayer can establish that the shortfall in the RMD was due to reasonable error and that reasonable steps are being taken to remedy the shortfall, the IRS has authority to waive the excess accumulation penalty on a case-by-case basis. Should a taxpayer find himself or herself in a situation where he or she has failed to take an RMD and is subject to the excess accumulation penalty, we recommend the taxpayer consult with their advisors to determine if filing a request for a waiver of the excess accumulation penalty is appropriate.

Improper titling on an inherited IRA

An IRA is treated as “inherited” if the individual for whose benefit the IRA is maintained acquired the IRA on the death of the original account owner. For example, Scott named his son, John, as the beneficiary of his IRA. Upon Scott’s passing, the IRA becomes an inherited IRA for John. The IRA will need to be retitled to take this new ownership into account. The key is to make sure that the inherited IRA is maintained in the deceased IRA owner’s name and is not improperly retitled in the beneficiary’s name (unless the beneficiary is the surviving spouse and the surviving spouse is executing a spousal rollover). Failure to ensure proper retitling of the IRA account may result in the entire IRA being treated as a taxable distribution to the account beneficiary. For example, the account could be retitled: Scott Smith, deceased, IRA for the benefit of John Smith. Doing so identifies the IRA as an inherited account by maintaining the deceased IRA owners name in the account title. Improper retitling of the IRA account in the beneficiary’s name, such as John Smith, IRA, may be treated by the IRS as a taxable distribution of the entire account to John, the account beneficiary. Therefore, we recommend that individuals who inherit a retirement account consult with their advisors to ensure the account is retitled correctly so that the account beneficiary is not subject to unnecessary tax.

Spousal rollover and avoiding the spousal rollover trap

A surviving spouse has the unique opportunity to roll over, into his or her own retirement account, retirement plan benefits left to him or her by his or her deceased spouse. A surviving spouse is the only beneficiary who has this opportunity. All other beneficiaries must treat the account as an inherited account and must begin taking distributions from the account by December 31 of the year following the year of death.

The key benefit of executing a spousal rollover is that the retirement account assets become the surviving spouse’s assets and therefore the surviving spouse is not forced to take required distributions from the assets until he or she reaches age 70 ½. However, by treating the retirement benefits as part of his or her own retirement account, the surviving spouse now exposes the plan assets to the 10 percent early withdrawal penalty should the assets be withdrawn from the account before the surviving spouse attains the age of 59 ½.

In the case where a surviving spouse is younger than 59 ½ and has a need to access the retirement assets of the deceased spouse, performing a spousal rollover will preclude the surviving spouse from accessing the account assets without incurring the 10 percent penalty for early distributions. Opportunities exist for mitigating this potential trap such as rolling over a portion of the retirement account while maintaining a portion of the retirement account in the deceased spouse’s name. We recommend that individuals inheriting a retirement account from a deceased spouse who are younger than 59 ½ contact their advisors to weigh the opportunities available to them and effectively plan for the distribution of the retirement account.

Rollovers and exceptions to the 60-day rollover rule

A rollover is a distribution from a retirement account to the account owner that the account owner then re-deposits into another retirement account. A rollover is not a “trustee-to-trustee transfer” or a “direct transfer” in which assets pass directly from the old plan to the new plan and which the owner never touches. By contrast, in a rollover, the account owner holds the distribution check in his or her hand before re-depositing it in another qualified account.

Generally, an account owner must complete the rollover no later than the sixtieth h day following the day on which the taxpayer received the distribution. If the rollover is not accomplished within the 60-day period, the distribution will generally be treated as a taxable distribution to the account owner. This adverse income tax event is generally not what the account owner was trying to accomplish and can be a disastrous result for the account owner. Therefore, we would recommend an account owner consider utilizing a trustee-to-trustee transfer to mover assets between retirement accounts. Doing so precludes the possibility that the transfer of assets will not be accomplished within the 60-day period because the assets are never distributed out of the account to the account owner.

Should the 60-day rollover timeframe be missed, the Service may waiver the 60-day requirement where the failure to do such would be against equity or good conscience, including casualty, disaster and other events beyond the reasonable control of the taxpayer. In making its determination to grant or deny the waiver, the Service will look at the relevant facts and circumstances including, errors committed by a financial institution, inability to complete a rollover due to death, disability, hospitalization, incarcerations or postal error. The Service will also take into consideration the use of the distributed funds (i.e., was the distribution check cashed and used for other purposes), and also the time elapsed since the distribution occurred. Should a taxpayer find himself or herself in a situation where he or she has failed to complete a timely 60-day rollover, we recommend the taxpayer consult with their advisors to determine if filing a request for a waiver of the 60-day period is appropriate.

Ensuring RMDs are not overlooked in the year of an account owner’s death

After the death of an account owner, the required minimum distribution rules apply to the account beneficiary. This is true even in the year of the account owner’s death for an account owner who has reached his or her required beginning date (i.e., who is over 70 ½ and was taking lifetime RMDs).

If the account owner took the full RMD for the year of death prior to his or her death, then nothing else needs to be withdrawn from the account for the year. However, if the account owner died before taking his or her full RMD for the year, then the responsibility for taking the balance of the RMD falls to the account beneficiary. The executor of the account owner’s estate does not need to be concerned about the RMD for the year of the account owner’s death unless the estate is the beneficiary of the account.

For example, assume Jill, who is 80 and owns an IRA, is required to take a $100,000 distribution from her IRA in 2014. Jill dies in January of 2014. She had only withdrawn $10,000 of her 2014 RMD prior to her death. Jill’s beneficiary designation form names her daughter, Jane, as the beneficiary of her IRA. Therefore, Jane, as the beneficiary of the IRA, is required to take the $90,000 balance of the 2014 RMD prior to December 31, 2014. If Jane does not take the balance of the 2014 RMD by December 31, 2014, she would be subject to the 50 percent excess accumulation penalty. Jill’s estate is not required to take the balance of the 2014 RMD, as the estate is not the beneficiary.

It is very easy in the year of an account owner’s death to forget about the RMD or incorrectly assume that the balance of the distribution should be taken by the account owner’s estate. Therefore, we recommend that executors of a decedent’s estate and beneficiaries of a decedent’s retirement account contact their advisors in the year of an account owner’s death to ensure that the balance of the year-of-death RMD is not inadvertently missed or taken by the wrong party.

Conclusion

The issues presented here are just a handful of the common mistakes that can be made with regard to retirement distributions. As is evident, the distribution rules regarding retirement accounts such as IRAs and QPs present many traps for the unwary. Therefore, we recommend that you consistently consult with your advisors regarding matters relating to retirement accounts.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.


The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.