Identifying, preventing, and mitigating common retirement distribution planning mistakes.

• Author: Voigt, Jennifer

Traditional individual retirement accounts (IRAs) and qualified retirement plans such as Sec. 401(k) plans frequently compose a significant portion of an individual's wealth. These accounts are subject to numerous and, often, complicated rules, and the penalties for failing to comply with these rules can be substantial. This item focuses on some of the more common retirement distribution planning mistakes and suggests ways to prevent and mitigate them. All references in this item to IRAs refer to traditional IRAs and not Roth IRAs.

Failure to Take Required Minimum Distributions and the Excess Accumulation Penalty

One of the most appealing features of IRAs and qualified plans is that they are tax-favored. Income and growth from assets in the accounts are allowed to accumulate on a tax-deferred basis and are not taxed until distributed to the account owner. Congress intended these accounts to be used by the account owner in retirement and not as wealth-transfer vehicles. To prevent the accumulation and transfer of wealth in and from retirement accounts, Sec. 401(a)(9) provides for required minimum distributions (RMDs).

Sec. 401(a)(9)(C) and Regs. Secs. 1.401(a)(9)-5, A-1(b) and (c) require distributions to be made from these accounts to the account owner, generally beginning when the account owner reaches age 70% or retires, with some exceptions. The first distribution needs to be made by April 1 of the calendar year following the year the owner turns age 70%. This is known as the required beginning date. Going forward, a distribution to the account owner must be made by Dec. 31 of each calendar year, beginning with the calendar year containing the required beginning date. Failure to take RMDs will result in the imposition of a 50% excise tax assessed pursuant to Sec. 4974(a) to the account owner for the shortfall, i.e., the amount that was required to be distributed but was not.

Example 1:M, age 80, owns an IRA. He is over age 70 1/2 and is taking annual RMDs from his retirement account. He was required to take an RMD of $250,000 for 2014 but took a distribution of only $100,000. His RMD shortfall is $150,000 ($250,000 RMD-$100,000 actual distribution). Therefore, he would be subject to $75,000 of excise tax ($150,000 RMD shortfall x 50%) for failing to take his full 2014 RMD.

As is evident in Example 1, the tax imposed for missed RMDs, also known as the excess accumulation penalty, is one of the steepest penalties the Code imposes with...