Laws regulating tax-deferred retirement plans including traditional Individual Retirement Accounts (IRAs), 401(k), SEP, Keough, and SIMPLE plans require holders of these plans to take minimum distributions the year following the year the holder turns 70 and one-half or face a tax liability for 50 percent of the amount they should have taken out. Few owners of tax-deferred assets who will be taking those distributions are prepared to manage the impact of the additional income on their taxes. Heirs to these assets must also take minimum distributions within a defined period of time or face the 50 percent penalty, and must plan for a sharp increase in ordinary income.
Because the rules about the timing and amounts of the distributions are complicated, tax professionals need to inform their clients about the possible consequences of their actions and assist them in planning the distributions.
Two exceptions include Roth IRA owners, who have already paid tax on their contributions, and individuals enrolled in a company pension or 401(k) plan who can wait until they actually retire to collect.
Most experts emphasize the importance of consulting a tax professional about the required distributions, because there is little help available from either the plan custodians or the Internal Revenue Service, even though the most recent data show that, as of 2006, assets held in IRAs and defined contribution plans, such as 401(k) plans, increased to $7.5 trillion up from about $4.8 trillion in 2000, according to CCH.
IRA custodians are now required to send the IRA owner a Form 5498, which notifies the owner (and the IRS) that an RMD is due the following year, according to IRS spokeswoman Dianne Besunder, Julie Jason writing in the Stamford Advocate reports, but there is no comparable form for 401(k) plans.
Custodians are not required to calculate the RMDs, but customers of Fidelity Investments can set up a "Personal Withdrawal Service Plan" that will calculate the required distributions, the Wall Street Journal says. Clients of Vanguard can use kits available on its site to calculate their minimum distributions.
Depending on who will be taking the distribution, whether the owner, the spouse or another beneficiary, the amount should be calculated using one of three tables based on life expectancy published by the IRS. The tables are not easy to find on the Agency's website. The taxpayer must navigate to Appendix C of Publication 590, Individual Retirement Arrangements.
One big pitfall that beneficiaries want to avoid, according to The Wall Street Journal: don't let the custodian write a check to you for the amount and deposit it in your own IRA, and unless you are a spouse, don't roll over the money directly into your own pre-existing IRA account. Both actions close out the original IRA, and the money is then taxable.
Non-spouse beneficiaries need to set up a trustee-to-trustee transfer before they move the money into retirement accounts in their own names. They must be knowledgeable about the timing rules for RMDs, for the decedent and for themselves. Multiple beneficiaries must learn numerous miscellaneous rules and understand that the RMD is based on the age of the oldest beneficiary.
IRA holders now have the option of contributing up to $100,000 of the distribution each year to a charity with no tax consequences, as long as the payment is made directly from the IRA to the charity. This rule does not apply to money from other retirement plans.