Advisor Insights

A Good Tax Idea Backfires

Natalie Choate

Question: Two years ago when I reached age 69 1/2, I rolled my $1 million IRA into the 401(k) plan at Big Co. where I then worked. Since I'm less than a 5% owner of Big Co., I knew this would mean I would not have to take a required minimum distribution from this plan as long as I was still working for the company. Last year I turned 70 1/2 and my scheme worked like a charm: No RMD is required from the Big Co. 401(k) plan until the "later of" the year I turn 70 1/2 or the year I retire--so there was no RMD in 2017.

Now it's 2018 and I retired in July (at age 71). I asked the 401(k) plan to transfer my entire 401(k) balance by "direct rollover" into my IRA. The plan administrator wouldn't do it unless it first paid me the entire 2018 RMD in cash. The plan administrator said that after I took out the fully taxable 2018 RMD, it would direct-roll the remainder of my 401(k) account into my IRA.

But if I have to take an RMD in 2018, I want to do at least part of it as a qualified charitable distribution (direct transfer to charity). I can only do QCDs from my IRA, not from a 401(k) plan. I've sworn to the plan administrator that if we can transfer the money into my IRA first, I'll take the RMD from the IRA (by means of a QCD). Help! I don't want to take the full RMD for 2018 and pay tax on it; I want it to be at least partly sheltered by a QCD. Please tell me the plan administrator is all wrong about this.

Answer: Sorry to bring bad news: The plan administrator is 100% right. There is no ambiguity or wiggle room here. A required minimum distribution cannot be rolled into an IRA (it's not an eligible rollover distribution), and the first money that comes out of any plan or IRA in any calendar year counts as the RMD for that year. You don't get a choice about what dollars will be your RMD--the first dollars coming out of the plan will be your RMD until it's paid in full. If the distribution exceeds the RMD, you can roll over the excess.

That means your 2018 RMD (if you take it this year) will be fully taxable to you. You cannot reduce the tax impact by using a QCD this year, because QCDs can only come from IRAs.

By skipping your 2017 RMD altogether (because all your money was in the 401(k) and you were still working that whole year), the tax impact of you 2018 RMD will be greater than it would have been had you left the money in the IRA. If the money were still in the IRA, you would have had to take a 2017 RMD and you could have used QCDs to reduce the tax impact of that RMD and the 2018 RMD.

You don't have to take the 401(k) plan 2018 RMD in 2018 at all, of course. Since this is your first "distribution year" (the later of the year you reach age 70 1/2 and the year you retire), you are entitled to postpone the first year's RMD until April 1 of the following year (2019). But if you take advantage of that postponement option, you will have two years' worth of RMDs next year (2018 plus 2019)--and you will still not be able to reduce the impact by using QCDs because the money will still be in a qualified plan (the 401(k) plan) as of Dec. 31, 2018.

If you swallow the medicine and take the fully taxable 2018 RMD this year, then complete the rollover of your remaining 401(k) balance to the IRA before the end of 2018, at least next year your money will all be in an IRA, and you can take all or part of your 2019 RMD in the form of QCDs (up to $100,000).

File this under "win some, lose some,” or "every silver lining has a cloud." 

Where to read more: Chapter 2 of Natalie Choate's book Life and Death Planning for Retirement Benefits (8th ed. 2019; www.ataxplan.com) explains all the rules for rollovers, including the problem of trying to roll over in your first RMD year. Chapter 1 explain RMDs including the required beginning date. Chapter 7 explains qualified charitable distributions. 

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie's book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.

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