Distributions in Year of Retirement: A Complicated Simple Question

Question: My client Paul retired from his firm effective Dec. 31, 2020, at age 73. He was not a "5% owner" of the firm. At the time he left, he had $850,000 in the firm's 401(k) plan and also owned a small ($10,000 as of Dec. 31, 2020) traditional IRA. In connection with his retirement, he had requested a direct transfer of his 401(k) plan balance into the IRA. The firm complied and has filed IRS Form 1099-R for 2020, showing a complete distribution of the $850,000 via direct rollover to Paul's IRA. However, the money did not reach the IRA account until January 2021, so the "prior year-end balance" of the IRA for 2020 was only $10,000. I have two questions: Is Paul's required minimum distribution for 2021 (the year he turns 74) from the IRA computed based on the $10,000 prior year-end account balance as shown on his account statement and the Form 5498 that will be filed by the IRA provider? And if so, can Paul still make qualified charitable distributions of $30,000 from the IRA in 2021 as he had originally intended to do?

Answer: At first glance, it looks like Paul has found a great way to avoid RMDs--just make sure the plan assets are in transit between different retirement accounts on the last day of the year. Unfortunately for this "planning idea," the IRS had thought of that. When determining the RMD for an IRA, there is an adjustment required in computing the prior year-end account balance: The balance must be increased by the amount of any "outstanding rollover" (rollover in transit into the account as of the last day of the prior year). (Treasury Reg. § 1.408-8, A-6, second sentence.)

So, Paul’s 2021 RMD from the IRA will be: Adjusted prior year-end balance of the IRA, divided by the factor from the Uniform Lifetime Table for age 74: ($10,000 + $850,000 = $860,000)/23.8 = $36,134.45.

Here are some other important points about Paul’s situation:

• The prior year-end balance adjustment is required only for rollovers in transit; it is not required for other kinds of contributions. For example, if Paul were to make a "2020 contribution" to the IRA during the period of Jan. 1 to April 15, 2021, that contribution would not go into his IRA's "prior year-end balance" for purposes of computing the 2021 RMD, even though it is a "2020 contribution." That's why it's recommended that people subject to RMDs not make their plan or IRA contributions for any year until after the end of that year (prior to the applicable deadline), so as to avoid unnecessarily increasing the prior year-end balance used to compute RMDs for the year the money is actually contributed.
• The life expectancy factor for 2021 is computed using the "old" IRS life expectancy tables for RMDs. A new table will become effective in 2022. In 2022, the year Paul will reach age 75, his RMD factor from the new Uniform Lifetime Table will be 24.6. Thanks to the new tables effective next year, we will all get a little younger, so Paul's RMD under the new table in 2022 will be a smaller percentage of his account than is required under the old table in 2021.
• Because Paul retired in 2020, his first required distribution year for the 401(k) plan was 2020: the "later of" the year he reached age 72 or the year he retired. Normally that would mean that an RMD was required for that year, and normally that would mean the 401(k) plan could not direct-roll any of Paul's account into an IRA until after it had paid Paul the RMD from the 401(k) plan for 2020. But since RMDs were eliminated for the year 2020 by the CARES Act, this "normal" scenario did not occur.

This fact surprises and upsets many retirees and their advisors: Even though a person who retires in Year 1 is not required to take his 401(k) plan RMD for that “distribution year” until April 1 of the following year, the plan is not allowed to make direct rollovers out of the retiree’s account until after it has distributed the RMD for the year of the rollover--and there is an RMD for the year of retirement, even though it has a delayed deadline until April 1 of the following year. The year the individual attains age 72 (or retires, if later, assuming he is not a 5% owner) is his “first distribution year.”

So, the retiree has a choice: Either leave the money in the 401(k) until the following year and take RMDs for both years (the year of retirement and the following year) in the following year (year after retirement), or roll the plan money into an IRA in the same year as retirement (but first take the RMD for such year from the 401(k) plan and pay tax on it, even though he could have deferred this distribution until April 1 of the following year if he didn’t insist on doing the rollover).

If you don’t believe me, read Reg. § 1.402(c)-2, A-7(a). That regulation specifies that an RMD is not an eligible rollover distribution; that no distribution from an account can be rolled over until after the RMD for such year has been distributed; and that the participant's first “distribution year” is the year he or she reaches age 72 or retires, whichever is applicable. Therefore, the plan cannot do a direct rollover in the year of the employee’s retirement unless it first pays him the (normally otherwise postponable) RMD for such year.

But Paul didn’t have that particular problem, because of the CARES Act: There were no RMDs for the year 2020, so the 401(k) plan did not have to pay Paul a 2020 RMD before rolling over the plan balance into Paul’s IRA in 2020.

Finally, let’s address Paul’s concerns about his QCDs. Paul thought that if he had no RMD from his IRA in 2021 (or only a small RMD), he could not make the full amount of QCDs he had intended to make in 2021 from that IRA. This is a misconception. There is absolutely no relation between the maximum amount of an individual’s permitted QCD ($100,000) and the amount of the individual’s RMD for the year. If your RMD is $200,000, your maximum QCD is $100,000. If your RMD is $1,000, your maximum QCD is still $100,000. In 2020, there were no RMDs at all thanks to the CARES Act--but each IRA owner over age 70½ could still make QCDs up to the maximum of $100,000.

The only relationship between QCDs and RMDs is that a QCD will count toward the obligation to take a required minimum distribution to the extent the RMD obligation has not already been fulfilled at the time of the QCD. So, for 2021, we have determined that Paul's RMD from the IRA will be $36,134.45. He can satisfy this, if he chooses, by making $30,000 of QCDs (as you say he intends to do for 2021) plus a distribution to himself of the remaining $6,134.45, and the RMD will generate only $6,134.45 of gross income to him for 2021. If, based on the lessons of 2020 (when Congress decided, in March 2020, to eliminate RMDs for the year 2020), Paul wants to wait until he is sure there is an RMD for 2021, he can hold off until later in the year to carry out his plan.

Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article do not necessarily reflect the views of Morningstar.