There’s no denying the tax benefits of funding a retirement account, one of which is the compound effect of tax-deferred growth. But your money can’t avoid the IRS forever.
That’s why owners and beneficiaries of traditional IRAs, SEP and SIMPLE IRAs, 401(k)s and 403(b) accounts must meet the deadline for taking their required minimum distributions (RMD), which kick in after you reach the age of 72.
The Required Minimum Distribution (RMD) was instituted by the government to stop retirees from deferring their retirement accounts forever (without needing to pay taxes). Uncle Sam doesn’t like that.
RMD’s are required from traditional IRA’s, 401k’s, or any other retirement account on which you have never paid taxes. This article focuses on traditional IRA accounts. Many of you believe that the RMD withdrawal is a large portion of your retirement account. It’s not.
At age 72 you are required to withdraw approximately 4% of your traditional IRA account value. The deadline for withdrawing your 1st RMD is by April 1 of the calendar year after you turn 72. However, the deadline for your 2nd and future RMDs is December 31 of each subsequent year.
Here is an example: Turned age 72 on August 11, 2021. 1st RMD Due April 1, 2022. 2nd RMD due by 12/31/2022. It is important to note that your first two RMDs are due in the same calendar year!
Where People Go Wrong
All too often, owners of traditional IRA plans make a costly mistake: They either end up miscalculating their RMD, or they take it from the wrong type of account. For example they may erroneously take a distribution from the other spouse's IRA.
There's more than a good chance that some retirement account owners will fail to properly take all of their required distributions. When an RMD is not correctly taken, any shortfall is subject to a 50% penalty. To put that in dollar figures, if you had an IRA worth $2,000,000 and you were 72 years old, your RMD would be approximately $78,125. If you somehow missed taking that required distribution you could owe the IRS a penalty of $39,062.
If you have multiple IRAs, you must calculate each account individually, but you can take your total RMD amount from one IRA or a combination of IRAs. Keep in mind that RMDs apply to traditional IRAs, but not Roth IRAs.
How to Fix Your Error
If you fail to take an RMD from a traditional IRA and take the proper action, you may be able to appeal the penalty. The IRS has the authority to waive the 50% RMD penalty when the shortfall is due to a reasonable error.
Step 1: Take corrective action
The first thing you should do after discovering your RMD was missed or you didn’t take the right amount is to take immediate corrective action. Calculate the shortfall and then remove that amount as soon as possible from the IRA. (For help on how to do the math, try an RMD calculator.)
Step 2: Use the form
Next, file tax form 5329, "Additional Taxes on Qualified Plans (Including IRAs) And Other Tax Favored Accounts." This form can be filed with your tax return or by itself. As long as you're requesting that the 50% penalty be waived, payment does not have to be made when the forms are filed.
Step 3: Write a letter
Along with the form 5329, you should attach a letter explaining the shortfall and the steps taken to rectify the error.
In addition, provide an explanation as to why you made the mistake in the first place. While there's no formal guidance on what a "reasonable error" is, some potential explanations that might pass IRS scrutiny include: illness, a death in the family, a change in address that disrupted essential communication regarding the RMD, or that you relied upon incorrect professional advice.
While there's no guarantee, if you follow these steps, there’s a possibility the IRS will waive the penalty. If so, you can expect to receive a notice from the IRS a few months after submitting the form 5329 confirming that they have waived the penalty. It’s a good idea to save this notice.
To Avoid Problems in the Future
Missing your traditional IRA RMD can be frustrating and costly. To ensure it does not happen, take the necessary steps to make sure the correct distribution occurs by the applicable deadline. Put a reminder on your calendar every January to calculate your RMD and make the withdrawal. Or, ask your financial advisor to do this for you. Some IRA custodians will provide an automatic RMD calculation and payment as well. You may want to inquire with your custodian.
Final thought.
Are you comfortable with your progress towards retirement? How about helping future generations meet their financial goals? If you have more than $2 million saved and need help from a wealth manager, the Peak Wealth Planning team can assist.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance, and estate planning advice. Peak Wealth Planning is a fee-based financial advisor based in Champaign, Illinois, and Fraser, Colorado.