Don't Rely on Brokerages or Fund Companies to Fix Your Missing RMDs

Question: I'm deciding what holdings to sell to meet minimum distributions from my retirement account for this year. What happens if I don't specify which part of the account from which the money should be distributed. 

Answer: With Dec. 31 fast approaching, now is the time of year that many retirees have required minimum distributions, or RMDs, on their minds. These are yearly withdrawals of funds from retirement accounts, such as 401(k)s and traditional IRAs, that must be taken beginning the year after the year in which the account holder turns age 70 1/2 (the deadline is April 1 the first year and Dec. 31 in subsequent years). Annual amounts are based on a formula that factors in life expectancy. The government requires RMDs as a way to move money out of tax-sheltered retirement accounts and into taxable accounts. For more on how RMDs are calculated, see this earlier Short Answer article.

The penalty for not taking enough RMDs in a given year is a 50% tax on any shortfall. So if you were supposed to take $20,000 in RMDs but took only $10,000, you'd have to pay an extra $5,000 in taxes. The IRS considers taking RMDs to be the individual's responsibility, not the financial institution's. (Individuals who are assessed a penalty may be able to get it waived if they can convince the Internal Revenue Service it was an honest mistake and take steps to fix the error.)

Communicating RMD Requirements
To help clients avoid incurring penalties, fund companies and brokerages may allow customers to have RMDs sent to them automatically so they won't risk forgetting to take them. As part of this service the client may be asked to specify which holdings should be sold to meet RMDs. Some firms require that RMDs be paid from the client's sweep account, meaning that investments have been converted to cash. Others allow RMDs to be taken directly from investment holdings. Christine Benz, Morningstar's director of personal finance, writes about how to decide which investments to tap for RMDs and provides other useful advice on the topic in this article.

But what happens if the client doesn't have enough in cash to meet RMDs and hasn't specified investments to be sold? Does the financial institution sell holdings anyway to save the client from incurring the tax penalty?

Firms Usually Won't Sell Assets to Meet RMDs
Representatives from Vanguard, Fidelity, and  T. Rowe Price Group (TROW) all said that if a client hasn't specified holdings to be sold to meet RMDs, their firm would reach out to the client to ask. If, however, the client provides no instructions regarding selling holdings to meet RMDs, and there is not enough money in the client's sweep account, the firms usually will not sell the client's holdings just to meet RMD requirements, the representatives said. A spokesman for T. Rowe Price said the RMD form that his firm asks clients to fill out does contain language authorizing the company to sell holdings in a client's IRA account on a proportional basis if the client has not specified what he or she would like sold, but added that such liquidations "very rarely" happen.

The reason firms usually won't sell client assets to meet RMDs is because clients may have holdings at other firms that they plan to sell to meet required distributions. For example, a client may have IRA accounts at three different fund companies. The size of the RMD would be based on the amount of assets in all the IRAs combined. But the actual distribution could come from just one of the IRA accounts. (This pooled approach to taking RMDs is only allowed for IRA and 403(b) accounts. For 401(k) accounts and most other retirement plans, RMDs must be taken from each account separately.)

A Fidelity spokeswoman said that as of Dec. 9, 48% of the firm's clients had yet to take their full RMDs for the year, down from 65% one month earlier. But she cautioned that there's no way to know how many of the company's clients also have retirement accounts at other firms.

The best way to avoid any anxiety about incurring a penalty for not taking enough RMDs is to automate the process. And the best way to ensure that your brokerage or fund company sells the investments you want sold is to specify this, as well. Whether you choose to sell assets proportionally, from one specific area of your portfolio, or using some other approach, you'll have one less thing to worry about when you've taken the necessary steps to avoid year-end problems with your retirement account.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.