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Retirement Perspectives

If you’re still working past 70 1/2, be aware of RMD pitfalls for the unwary.

Last week, I covered the “still working” required minimum distribution (RMD) exception that applies to some to 401(k) plans. In this week’s column, I feel it prudent to highlight a particularly common mistake, and offer a few RMD practice tips.

Lifetime IRA RMD Rule
Owners of traditional IRAs (as well as SEP and SIMPLE IRAs) typically must commence taking minimum distributions when they reach age 70½, although they may postpone the initial year’s RMD as detailed below. However, account owners who postpone the initial RMD are required to take two distributions in the following year. In each subsequent year, the RMD must be taken by December 31, or suffer a 50% federal penalty tax.

RMD rules differ for qualified plans, such as 401(k)s. Unlike IRAs (traditional IRA, SEP, or SIMPLE), certain 401(k) plan participants potentially can defer RMDs to the later of either the end of the calendar year in which they reach age 70½ or to the year in which they retire.

While  the required beginning date (RBD) for RMDs is generally April 1 of the year following the year the account owner/plan participant reaches age 70½, there is an exception that may apply if an individual continues to work (i.e., “still working”) for the employer sponsoring the 401(k) plan. This exception is available only if it’s allowed by the plan and the individual does not own more than 5% of the company. In other words, a plan is not required to include thei “still working” exception as part of the plan. Be sure to review the plan document or Summary Plan Description (SPD) to determine if this provision applies.

Here’s an example of an all too common RMD error:

Janice, 74, retires from XYZ Company, Inc. on November 1, 2017. Janice, who is not a 5% owner, was using the “still working” exception by delaying her RMD. Janice subsequently rolls over her $500,000 401(k) account into a traditional IRA, preserving tax-deferred treatment.

Later in the year Janice, now working with an advisor, is informed that she should have taken her RMD of $21,000 prior to rolling of the remaining balance to an IRA. Since RMDs cannot be rolled over into an IRA, Janice has an excess IRA contribution in the amount of the RMD (i.e., $21,000.)

Unfortunately, the correction isn’t as simple as distributing the equivalent of the RMD from the IRA. For one thing, RMDs can’t be rolled over. Instead, Janice now must contact her IRA custodian to remove the excess.

If there’s a silver lining to this issue, it’s that there are specific steps to follow to correct excess contribution. The RMD amount (e.g. $21,000) and any earnings (referred to as “net income attributable,” or NIA) must be distributed from the IRA by October 15 of the year following the year of the excess contribution. The custodian will distribute the excess (including NIA) and report the distribution on Form 1099-R. Note: Only the NIA will be taxable when distributed from the IRA, while the RMD amount will be treated as taxable distribution from the 401(k) plan.

Missing the aforementioned deadline for correcting the issue subjects the IRA account owner to a 6% penalty for each year the excess remains in the IRA. Unfortunately, there are too many instances in which the rollover is completed without the 401(k) RMD being taken first.

I can’t stress enough how important it is to be aware of this potential pitfall, which I am seeing all too frequently, as workers remain at their jobs well into their seventies, and beyond.

“Still Working” Exception RMD Tips

  • A 401(k) plan is not required to offer the “still working” exception.
  • A client using the still working exception should contact his/her 401(k) administrator, or the record keeper to determine and process the RMD amount prior to the rollover.
  • Unlike Roth IRAs, Roth 401(k) funds are subject to lifetime RMDs.  A plan participant using the still working exception; his/her Roth 401(k) dollars would also be subject to RMDs in the year of separation, prior to rolling the remaining Roth balance into a Roth IRA.
  • The still working exception does not apply to IRAs (including SEP and SIMPLEs).
  • Employees aged 70½ or older are eligible to participate in a SEP or SIMPLE IRA, assuming they satisfied the plan’s eligibility requirements; however, once an employee reaches 70½, RMDs are required. 

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

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