How to Save Clients from RMD Aggregation Mistakes

When IRA and qualified plan owners turn 70½, the IRS requires them to begin taking out required minimum distributions (RMDs) from their tax-deferred savings accounts, regardless of whether they want to begin taking distributions or not. But there are many errors that are commonly committed with these distributions and account owners need to know the rules that apply to them in order to avoid these errors and minimize their tax bills. The key is to know what the IRS rules are pertaining to RMDs and how they are taxed.

The Rules

The IRS requires that all owners of a traditional IRA or qualified plan begin taking mandatory minimum distributions from their accounts by May 1st of the year after the year in which they reach age 70½. This means that an account owner who reaches age 70 in October of a given year will not have to begin taking distributions until two years later, on May 1st of the year after which he or she becomes 70½. This can have a substantial impact on the amount of distributions that are taken over the life of the account owner. (For more, see: How to Calculate Required Minimum Distributions.)

But many IRA and qualified plan owners think that they can stay in the clear by taking just one aggregate distribution from one plan or account that covers all of the required minimum distributions that are required by all of their accounts may be in for a rude surprise. There is a specific set of rules that applies to taking aggregate required minimum distributions. Both advisors and clients need to understand how these rules work in order to avoid the ghastly penalties that come from failure to take these distributions in a correct manner.

The IRS rules mandate that all required minimum distributions be calculated on a separate basis. When aggregation is allowed, these distributions can be taken on an aggregate basis from one or more of these accounts or plans. It’s important for advisors to understand  that accounts with a required minimum distribution pending cannot simply be rolled over into another account and have this RMD requirement incorporated into the new account. The required minimum distribution is considered by the IRS to be the first distribution taken from an account during the year. This means that an IRA investment in a fixed-income security that matures in March cannot be rolled over in its entirety during the year. The amount of the required minimum distribution must be subtracted from the amount than can be rolled over during the year.

The same rule applies when distributions are taken from an employer-sponsored retirement plan, even if those distributions are rolled over into an IRA or another qualified plan. All distributions from these plans are coded as rollovers, even when they go directly into another IRA or qualified plan. However, the required minimum distributions from an IRA can be moved directly from one account into another during the year. This allows the IRA owner to defer declaring the income from the distribution until later in the year. Advisors need to be certain that they have adequate reminders in place regarding the required minimum distributions, because the new IRA custodian will not have this information and will not know to alert the account owner to begin taking RMDs in many cases. (For more, see: Top Tips to Reduce Required Minimum Distributions.)

Another key rule to remember is that required minimum distributions from one type of account cannot be taken from another type of account. For example, an RMD from a 401(k) account cannot be taken from an IRA and vice versa. Each type of account must calculate its own separate required minimum distribution in order to satisfy IRS requirements.

But required minimum distributions for like-kind accounts can be aggregated. A client who owns a traditional IRA, SEP-IRA and a SIMPLE IRA can aggregate these distributions and take them from one account. Of course, the RMD should be calculated separately for each account, but the aggregate amount can be taken from a single account.

A similar rule applies for 403(b) accounts. But this rule does not apply to retirement accounts that the client has in the private sector, such as 401(k) or 457(b) accounts. The employee is required to take a separate RMD from each of these accounts in accordance with IRS regulations. And any plan that is making a series of substantially equal payments under section 72(t) of the Internal Revenue Code cannot be aggregated with any other payments that are made.

The Bottom Line

It is vitally important that advisors notify their clients of the required minimum distributions that they must take from their retirement plans and accounts. Some RMDs can be aggregated while others must be calculated and taken separately. Advisors need to know the rules surrounding these distributions in order to adequately advise their clients of their options and responsibilities. (For more, see: A Required Minimum Distribution Reminder.)