By Denise Appleby https://www.linkedin.com/in/deniseappleby
Owners of retirement accounts (participants) and beneficiaries with inherited accounts (beneficiaries) must take any required minimum distributions (RMDs) by the applicable deadline. Generally, an RMD for a year must be distributed by December 31st of that year. If an RMD is not taken by the deadline, the account owner owes the IRS an excise tax for excess accumulation, which is 50% of the RMD shortfall. This excise tax is waived if the deadline is missed due to what the IRS refers to as “reasonable error”, or if the account owner qualifies for an automatic waiver. The proposed RMD regulations, issued on 02/24/2022, modifies the rules by making it easier for some to avoid this 50% excise tax.
Note: For this purpose, retirement accounts include qualified plans, 403(b) accounts, governmental 457(b) plans, and IRAs.
Effective Date of These Modifications
These modifications apply to taxable years beginning on or after January 1, 2022.
The year 2021 is also covered providing the account owner operated under a reasonable, good-faith interpretation of the amendments made by the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act). According to the proposed RMD regulations, compliance with these proposed regulations will satisfy this requirement.
Reminder: RMDs for 2020 were waived under the Coronavirus Aid, Relief, and Economic Security Act.
Participants must start taking RMDs for the year they reach age 72 and continue for every year after. If the account is held under an employer-sponsored retirement plan (a retirement account that is not a traditional, SEP, or SIMPLE IRA), RMDs can be deferred past age 72 until retirement if allowed under the terms of the plan.
RMDs do not apply to Roth IRA owners.
Beneficiaries must also take RMDs from their inherited retirement accounts, including those with inherited Roth IRAs. Whether an RMD is due for a year from a beneficiary account depends on the distribution options that apply to the beneficiary.
A participant or beneficiary that fails to take any RMD by the applicable deadline owes the IRS an excise tax of 50% of the RMD shortfall. This excise tax is waived if the participant or beneficiary satisfactorily demonstrates to the IRS that the failure was due to reasonable error and that reasonable steps are being taken to remedy the failure. In some cases, the excise tax is automatically waived.
Account owners that owe the excise tax must report the amount on IRS Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts (Form 5329). Form 5329 must be filed whether the excise tax is being paid or a waiver of the penalty is being requested.
More Background: Changes Made by the SECURE Act
The SECURE Act increased the age by which participants must begin taking RMDs and modified the distribution options for beneficiaries. The following are highlights of some of these changes that affect the application of the 50% excise tax on excess accumulation in a retirement account.
Increase in Age for First RMD Year
The changes made by the SECURE Act include increasing the starting age for RMDs from 70 ½ to 72, effective for those who reach age 70 ½ after 2019. As a result, those who reached age 70 ½ before 2020 were required to take their first RMD for the year in which they reached age 70 ½, and those who reach age 70 ½ after 2019 must take their first RMD for the year in which they reach age 72 (the first distribution calendar year (FDCY)).
If the account is held under an employer-sponsored retirement plan the FDCY can be deferred past age 72 (or 70 ½ before 2020) until the participant retires from service with the employer that provides the retirement plan, providing such deferral is permitted under the terms of the plan.
The New Required Beginning Date
Generally, an RMD must be taken by December 31 of the year to which the RMD applies. An exception applies to the FDCY, under which the RMD for the FDCY can be taken as late as April 1 of the following year. This April 1 deadline is the participant’s required beginning date (RBD).
Because the FDCY has been increased to age 72, the RBD is now April 1 of the year that follows the year in which the participant reached age 72 (or- for employer plans-the age of retiring from working with the plan sponsor- if later and available under the plan,).
New Beneficiary Options for Inherited Accounts
The distribution options for accounts inherited before 2020 are determined by factors that include whether the beneficiary is a designated beneficiary (a person or a qualified see-through trust) and whether the participant died before the RBD. For retirement accounts inherited before 2020, a designated beneficiary was eligible to take distributions under any applicable life expectancy method if allowed under the terms of the governing IRA agreement or plan document.
The SECURE Act made significant changes to the distribution options for inherited retirement accounts, one of which is eliminating the life expectancy options for certain designated beneficiaries who inherited retirement accounts after 2019.
Other SECURE Act changes include (a) adding a new 10-year rule for designated beneficiaries, under which an inherited account must generally be fully distributed by the end of the 10th year that follows the year in which the participant died, but distributions are optional for years one through nine; and (b) adding a new category of beneficiary – eligible designated beneficiaries – effective for retirement accounts inherited after 2019. An eligible designated beneficiary is any designated beneficiary, who, as of the date of the participant’s death, is any of the following:
- The surviving spouse of the participant,
- A child of the participant who has not reached the age of majority,
- A chronically ill individual, subject to certain exceptions, or
- An individual who does not fall into any of the above categories and is not more than 10 years younger than the participant.
Critical Alert: Annual RMDs for Designated Beneficiaries Might Mean Missed 2021 RMDs
For accounts inherited after 2019, designated beneficiaries are no longer eligible to take distributions under the life expectancy method. According to the proposed RMD regulations, an exception applies if the participant died on/after the RBD. Under this exception, a designated beneficiary would be subject to an RMD-combo rule (author’s terminology), under which (a) distributions would be made over the applicable life expectancy beginning the year that follows the year in which the participant died, and (b) the account must be fully distributed by the end of the 10-year period.
The language in the SECURE Act and IRS Publication 590-B indicated that this life expectancy requirement in (a) does not apply to designated beneficiaries regardless of whether the participant died before or on/after RBD, which would mean that there would be no RMD due for the first nine years after the participant’s death. Designated beneficiaries who inherited retirement accounts from participants who died on/after the RBD and did not their RMDs and would owe the IRS a 50% excise tax for those RMD shortfalls. This is likely the case for those who operated based on the language in the SECURE Act IRS Publication 590-B.
This particular RMD shortfall issue would affect only individuals who inherited accounts from participants who died in 2020, where the death occurred on/after the RBD, and did not take RMDs for 2021. Individuals who inherit retirement accounts after 2020 would hopefully be made aware of these requirements and start their RMDs by the end of the year that follows the year of the participant’s death.
RMDs for Eligible Designated Beneficiaries
Eligible designated beneficiaries may take distributions under the life expectancy rule or the 10-year rule if the participant died before the RBD. If the participant died on/after the RBD, the eligible designated beneficiary is subject to the RMD combo-rule.
Beneficiary RMDs Might Be Accelerated
In some cases, distributions are accelerated under the RMD-Combo rule, requiring the account to be fully distributed earlier than the 10-year period. This appears to be the case where the beneficiary distribution period would have ended before the 10-year period, had the 10-year period not been an option.
The following is a high-level summary of the distribution options for beneficiaries, as available under the proposed RMD regulations.
|Pre-SECURE: Participant dies 12/31/2019 or earlier||SECURE: Participant dies after 12/31/2019|
|Death before the RBD||Death on/after the RBD||Death before the RBD||Death on/after the RBD|
|Eligible Designated Beneficiary||
Changes to the Excise Tax Rules under the Proposed RMD Regulations
The 50% excise tax on an RMD shortfall is generally due for the year to which the RMD applies. The proposed RMD regulations include an exception to this rule as well as modifications that reflect changes made under the SECURE Act. The following are some key changes:
Extension for first distribution calendar year
The excise tax is generally owed for the year that the RMD should have been taken. This includes the FDCY that is required to be taken by the RBD. Under the proposed regulations, the excise tax for the FDCY would be due for the year that includes the RBD.
IRS Form 5329 must be filed for the year to which the RMD failure applies. For example, if the deadline was missed for 2022, the 2022 version of Form 5329 must be filed to address that 2022 excise tax. It is the author’s opinion that the proposed RMD regulations would change the year for the Form 5329, for the FDCY.
Example 1- Old Rules
Sandra reached age 72 in 2021. Her FDCY is 2021 and her RBD is April 1, 2022.
Sandra fails to take her 2021 RMD by April 1, 2022.
Sandra owes the 50% excise tax on her RMD shortfall for 2021. Her tax preparer must file IRS Form 5329 for 2021.
Example 2- New Rules
Elaine reached age 72 in 2022. Her FDCY is 2022 and her RBD is April 1, 2023.
Elaine fails to take her 2022 RMD by April 1, 2023.
Elaine owes the 50% excise tax on her RMD shortfall for 2023. Her tax preparer must file IRS form 5329 for 2023.
Automatic Waiver by switching from Life Expectancy to the 10-Year rule
Under the pre-SECURE Act rules, if a participant died before the RBD and the beneficiary was a designated beneficiary, the options were to take distributions over the beneficiary’s life expectancy or under the 5-year rule. Under the life-expectancy rule, RMDs must be taken every year, starting with the year that follows the year in which the participant died.
A beneficiary who was subject to the life-expectancy rule but failed to take RMDs for any of the first four years would automatically avoid the excise tax by switching to the 5-year rule.
Under the proposed RMD regulations, this 5-year period is extended to 10 years, and the penalty is automatically waived if:
- The beneficiary is an eligible designated beneficiary who did not affirmatively elect to use the life-expectancy rule but is subject to the life-expectancy rule either under the default provisions of the governing IRA agreement or plan document or based on regulations. And
- The beneficiary elects the 10-year rule. This would make distributions optional for years one through nine, and any amount remaining at the end of the 10-year period would be the RMD amount and must be fully distributed by then.
Automatic Waiver if RMD for Year of Death is Taken by Tax Filing Due Date
If a participant died before taking an RMD that is due for the year of death, that RMD must be satisfied by the beneficiary. Under the old rules, the beneficiary would owe the excise tax if that RMD was not taken by December 31st of the year of the participant’s death. The proposed regulations provide that the penalty is automatically waived if the beneficiary takes that RMD by the beneficiary’s tax filing due date for the year to which the RMD applies, including extensions.
In all other instances, the excise tax is owed for any RMD not taken by the deadline, and Form 5329 must be filed to either pay the excise tax or request a waiver for the year to which the RMD applies.
Advisor Action Plan
The 50% excise tax is a stiff penalty and should be avoided at all costs. But the fact is that even participants and beneficiaries with the best-laid plans can miss their RMD deadlines. Advisors can help by following up with beneficiaries to make sure that they meet any RMD obligations.
Of seemingly critical importance is beneficiary RMDs for 2021 and 2022, where the beneficiary is a designated beneficiary who inherited an account from a participant who died on/after the RBD, and that death occurred in 2020 or 2021. If these designated beneficiaries are operating under the understanding that they are not required to take annual RMDs, advisors should follow-up and explain why they might need to take annual RMDs after-all. For those who inherited accounts in 2020, annual RMDs would be required including for 2021 and 2022. For those who inherited accounts in 2021, annual RMDs would be required beginning for 2021 .
The IRS could issue a blanket waiver for these RMDs because of the confusion created by the SECURE Act language and the explanations provided in Publication 590-B. Those who would prefer not to distribute those amounts could wait until it gets close to the end of the year and take the RMD amounts then if no waiver is issued.
Bear in mind, that these are based on the proposed regulations and while seemingly unlikely, they could be changed under the final regulations.