Updated January 10, 2024
By 2030, the baby boomer generation will be 65 years of age or older. That translates to the number of people who will need to take their Required Minimum Distributions (RMDs) from their IRAs and 401(k) plans.
With these numbers, it’s becoming increasingly important for advisers to guide clients in taking out RMDs from their retirement accounts.
This ought to be one of the simplest processes in the US tax code. But surprisingly, “as simple as it is, it seems to generate a lot of mistakes as well as planning opportunities,” says Natalie Choate, Trust & Estates attorney at Nutter, McClennen & Fish.
According to Ms. Choate, these are the common mistakes people can make when it comes to their RMDs. InvestmentNews suggests that investors and financial advisers take note of these common errors and avoid making them.
The Required Minimum Distribution or RMD is the government-mandated withdrawal that account holders of retirement accounts must make yearly. These are withdrawals from IRAs or 401(k) plans. This is also the minimum amount that must be withdrawn after the account holder reaches a certain age. These withdrawals are compulsory to ensure compliance with federal tax laws.
Previously, RMDs had to be made when account holders turned 70½. Due to the SECURE Act 2.0 of 2022, IRA and 401(k) account holders must now make withdrawals when they reach 73.
You may have noticed that RMDs go up or down with each passing year. Starting from the first RMD withdrawal, the life expectancy factor or distribution period changes. This prompts a re-calculation of the RMDs for succeeding years. As the account holder ages, their factor decreases and the RMDs they must withdraw gets higher.
Here are some of the most common mistakes people make when it comes to getting their RMDs:
Due to the SECURE Act, account holders born before 1960 must start taking RMDs in the year they turn 73. Those born later must start taking RMDs in the year they turn 75.
The IRS takes into consideration that first-time takers of RMDs need some time to prepare for withdrawals. The first RMD can be deferred to as late as April 1 of the following year when they turn 73 or 75.
While it may seem convenient, this can work against your client’s financial well-being. Holding off on the first RMD can mean taking on two RMDs in less than a year; the one held over to the end of March, and the regular December 31 RMD.
If the money held in the account is a significant amount, this will of course translate into large RMDs. This can result in not one but two potentially large taxable withdrawals within the same year.
The next common mistake is forgetting to take the yearly RMD. The IRS slaps a 25% penalty on the RMD amount if it’s not withdrawn by the prescribed deadline.
One way to avoid this simple mistake is to have the financial institution that holds the IRA or 401(k) set up their automatic RMD withdrawals feature. These withdrawals can be conveniently set to pay out your RMD monthly, quarterly, semi-annually, or annually.
By using the automatic distribution feature, account holders don’t have to worry about forgetting to withdraw their RMDs, and the financial institution disburses the right amounts.
Doing this can cause confusion and unwanted complications. It’s true that there are several benefits you reap as a married couple, but combining RMDs are not among them. Retirement accounts are held separately, not jointly – and that is how their RMDs should be handled.
In some instances, couples assume that they can withdraw the entire annual RMD from one of the spouse’s accounts. If a couple commits this mistake, the spouse whose account was not withdrawn from will be considered as the one having missed their RMD for that year.
This triggers the 25% penalty from the IRS. What’s more, the spouse who combined their RMDs will be placed in a higher tax bracket and pay much higher income tax – this is a costly double-whammy!
Those with different kinds of retirement accounts should understand the rules regarding RMDs for each account. Account holders are not allowed to use or withdraw from different types of accounts to fulfill the annual minimum distributions of one of the accounts.
For example, combined withdrawals from both your traditional IRA and your 401(k) plans cannot be used to comply with the yearly RMD for one of these accounts. However, you can withdraw different amounts from several accounts of the same type to come up with the RMD for one of these accounts.
Finally, the last most common mistake when it comes to taking RMDs is withdrawing the wrong amount. If the account holder withdraws less than the RMD for that year, that can result in an IRS penalty that’s equal to at most 25% of the withdrawn amount.
To avoid withdrawing more or less than the RMD for the year, there are online RMD calculators that account holders can use. They must calculate their RMD for the year using the account balance as of December 31 of last year, but that may not be the only consideration.
As the account holder gets older, their RMDs increase. This is simply a function of the IRA’s life expectancy table that governs RMD calculations. To make calculations easier, you can use the worksheets supplied by the IRS.
While many financial institutions usually do these calculations for account holders, it’s still the account holders’ responsibility to withdraw the correct amounts for their RMDs.
If an account holder keeps several traditional IRA accounts for the benefits, all their balances are added, then divided by the life-expectancy factor based on age. They can then withdraw the money from any of these traditional IRA accounts (remember that Roth IRAs no longer have RMDs).
For those with more than one 401(k), the RMD must be calculated separately for each of the accounts, then RMDs withdrawn from each.
Account holders who are over 70½ years old and still working don’t have to take RMDs from their current employer’s 401(k) plan. However, they must take RMDs from their previous employers’ 401(k) plans and traditional IRAs – even if they’re employed.
1. Account holders must take the RMD as soon as possible. They should take it as a separate RMD to avoid having it bunched up with the RMD for that year.
2. Once they’ve taken the missed RMD, they should fill out IRS Form 5329 for every year they missed an RMD. Each year has a corresponding form (i.e., missed RMDs for 2019 should be filed on a 2019 Form 5329). The IRS website has downloadable 5329 Forms dating back to 1975.
3. Fill out separate 5329 forms for each applicable tax year and repeat the same steps described above.
4. The account holder should write a letter explaining why the IRA should waive the penalty. The letter should be as brief and concise as possible, and include the crucial points only:
5. Once completed, the form/s should be mailed to the IRS along with the explanation letter. All forms must be signed.
There’s no need to file a 1040X to rectify the taxes for the year that the RMD was missed. Taxes on the amount taken to correct the deficient RMD will come due in the year the funds are paid out.
Should an account owner fail to withdraw the RMD amount when it falls due, the remaining amount would have had a 50% excise tax on it. Thanks to the new provisions of the SECURE Act 2.0, the excise tax penalty has since been reduced to only 25%. This goes down to 10% if the RMD is corrected within a two-year period.
This video discusses the reduction of the penalty on missed or erroneous RMDs, along with other changes to RMD rules with the passage of SECURE Act 2.0:
In this case, the account owner files IRS Form 5329 along with their federal tax return for the year when the entire amount of the RMD was required but not fully withdrawn.
Common mistakes in RMDs like neglecting or forgetting to withdraw the right amounts at the right time can be easily avoided. In those cases, account owners can request the financial institutions handling their accounts to automate the distributions. It also helps to identify which clients are due for RMDs.
If a client misses an RMD distribution or withdraws the wrong amount, they should notify the IRS of their mistake. They should complete the appropriate forms and send a letter explaining the error.
The IRS can be very forgiving, even when it comes to RMD mistakes. The IRS’s patience and consideration for these mistakes is further evidenced by the reduced penalties for these errors. In fact, the IRS often waives the penalties whenever mistakes are self-reported and promptly corrected with Form 5329.
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