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Late Retirement

For some people in some retirement plans, the 'required beginning date' for minimum distributions doesn't arrive until retirement.

Natalie Choate, 07/13/2012

Natalie Choate will be speaking at a location near you if you live in Boston (9/12/12 and 11/19/12); Philadelphia (7/18/12); South Bend (9/20/12) or Evansville (11/16/12), Ind.; Salt Lake City (9/28/12); San Antonio (10/1/12); Minneapolis, Minn. (10/9/12); Atlanta (10/19/12); San Diego (10/20/12); Albany, N.Y. (10/23/12); Iselin, N.J. (10/24/12); Orlando, Fla. (Jan.17–18, 2013); or Overland Park, Kan. (4/26/13). See all of Natalie's upcoming speaking events.

Normally minimum required distributions start at age 70½, but for some people in some retirement plans, the "required beginning date" for minimum distributions doesn't arrive until retirement. Here are some recent questions from my readers about that "special deal."

Question: My client "Jeff," who is turning age 75 in 2012, retired from his job at Giant Company on Dec. 31, 2011. Jeff was not a "five percent owner" of Giant, so he was not required to take any minimum distributions from Giant's plans until retirement. In January 2012, the Giant Co. profit-sharing plan sent his entire plan balance of $200,000 via direct rollover into Jeff's IRA, which I administer. The IRA balance as of Dec. 31, 2011, was $1 million. With the addition of the direct rollover, the balance is now $1.2 million. Jeff took his minimum distribution for 2011 from his IRA, but he has not taken any distribution yet from the IRA for 2012, and he never received any distributions at all from the profit-sharing plan. How do I compute his 2012 minimum distribution from the IRA? Has this been handled correctly so far?

Answer: The plan did not handle the terminating distribution correctly.

Because Jeff retired "in" calendar year 2011, 2011 was his first "distribution year" with respect to the Giant profit-sharing plan. His "required beginning date" (the deadline for taking the 2011 required distribution from the plan) was therefore April 1, 2012. Accordingly, the plan should have paid to Jeff directly the plan's minimum required distribution for 2011. A minimum required distribution is not an "eligible rollover distribution," and therefore a plan is supposed to pay the minimum required distribution directly to the retired employee personally before the plan transmits any direct rollover funds to the individual's IRA.

Furthermore, since the plan did not distribute anything from the account until January 2012, Jeff (even though he retired in 2011) was still a plan participant as of the beginning of 2012, and therefore another minimum distribution from the profit-sharing plan "accrued" for the year 2012. This amount also should have been distributed by the plan directly to Jeff and not transferred (rolled over) to Jeff's IRA.

Let's say Jeff's minimum required distribution from the Giant plan for the year 2011 was $8,000, and his 2012 required distribution from the plan was $9,000, for a total of $17,000. That amount ($17,000) should have been distributed by the plan directly to Jeff (with no income taxes withheld unless he requested them to do so). Instead it was direct-rolled into Jeff's IRA.

However, even though it's the plan that made the mistake here, it's the employee who must pay the price, and you (as his advisor) who must help him clean up the mess. Because the money was actually distributed out of the Giant profit-sharing plan, the IRS deems that the minimum distribution was in fact taken. Therefore there is no 50% penalty for a "missed minimum required distribution." The penalty for a missed required distribution in our example would have been $8,500 (50% times $17,000). That's the good news.

Now for the bad news. First, of course, the $17,000 minimum distribution that Jeff is "deemed" to have received in 2012 (he didn't actually receive it; it went directly into his IRA) constitutes taxable income to him. So he will have $17,000 of taxable income reflecting this plan distribution in 2012. Normally a rollover erases the taxable income from a distribution, but that doesn't happen if the rollover is invalid, as this one was to the extent of $17,000.

More bad news: Since those "minimum distributions" were not eligible rollover distributions, Jeff is deemed to have made excess contributions to his IRA. He is not eligible to contribute at all to a traditional IRA in 2012 because he is over age 70½. The penalty for an excess IRA contribution is 6% of the excess amount. Based on our approximate numbers, Jeff would be facing a $1,020 "excess IRA contribution" penalty for 2012 (6% times $17,000) because he is deemed to have made a regular contribution of $17,000 when his regular contribution limit was zero.

As a reminder: The IRS recognizes only two types of contributions to an IRA: rollover contributions and regular contributions. If a contribution does not meet the requirements of a valid rollover, then it is a regular contribution. And regular contributions are subject to limits and rules, one of which is that you cannot contribute to a traditional IRA if you have reached age 70½. If nothing is done, that penalty will continue to accrue at the rate of 6% per year every year until the excess contribution is removed.

Fortunately there is a way out of this box and a way for Jeff to avoid the penalty. He can remove the $17,000 from the IRA, along with any "earnings" that have accrued on the excess contribution between the date it landed in his IRA and the date he removes it. If he removes the contribution and its associated earnings by Oct. 15, 2013, he will have a successful "corrective distribution" that will erase his excess contribution and its associated penalty.

The easy part of this question is how to compute the minimum distribution from the IRA for the year 2012. Use the Dec. 31, 2011, account balance; ignore the rollover received in 2012 (because it was distributed from the other plan after Dec. 31, 2011). Beginning in 2013, the rollover balance will be included in the "prior year-end value" calculation base for minimum distributions from the IRA.

Question: "Rosie" is also an employee of Giant Co. She is turning age 74 in 2012. As a non-five-percent owner, she has been taking advantage of the ability to defer the commencement of minimum required distributions from the Giant profit-sharing plan until actual retirement. The question is, when is she deemed to have "retired?" She last worked at a desk in Giant Co.'s office in early 2012. At the end of February 2012, she started a one-year paid leave of absence under Giant's "sabbatical" policy. However, when the year expires, Feb. 28, 2013, she will probably not come back to work; she'll just retire. Would the IRS consider her "retired" already, since she is not actively working?

Answer: I have searched far and wide and consulted numerous experts, looking for any IRS definition of "retires from employment with the employer maintaining the plan" that would apply for purposes of the minimum distribution rules. The only IRS pronouncements related to this question deal with the definition of "employer maintaining the plan." The IRS has never uttered a peep about what "retires from the employment" means.

Therefore my conclusion would be that the only definition you have is the plan's definition. It's up to the plan to determine, based on fair and uniformly applied rules, whether a particular employee is considered "retired." Absent any fraud or bad faith by the employer, the plan's rules are the best available test. See if the plan has a definition. See if the plan and/or the employer still carries Rose as an "employee" on their books for purposes of such things as vesting in the plan, accruing benefits under the plan, and other employee benefits such as health insurance, etc. If the plan and the company do not consider her "retired," I don't see how the IRS could do so. But since my opinion is not exactly "cite-able authority," you might want to get a ruling!

Resources: For the rule that distributions must begin by April 1 of the year after the year in which the employee retires (if later than the year he reaches age 70½), see § 401(a)(9)(C) and Reg. § 1.401(a)(9)-2, A-2(a), discussed at ¶ 1.4.04 of the author's book Life and Death Planning for Retirement Benefits (7th ed. 2011; www.ataxplan.com). For the rules that minimum required distributions cannot be rolled over, and that the first money coming out of a plan in any particular year is the minimum required distribution, see ¶ 2.6.03 of Life and Death Planning for Retirement Benefits.

For how to make a corrective distribution, and the income tax and penalty-erasing effects thereof, see ¶ 2.1.08 of Life and Death Planning for Retirement Benefits, or the Natalie Choate Special Report: IRAs with Hair, downloadable at www.ataxplan.com.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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