Damage Control for a Missed RMD
Investors older than 70 1/2 must withdraw an IRA required minimum distribution (RMD) from traditional/SEP/SIMPLE IRAs and 401(k)s by the applicable deadline--normally the end of each calendar year. Failure to take all or part of the RMD by the applicable deadline results in a penalty of 50% of the shortfall. The IRS calls this the "excess accumulations" tax.
The IRS can waive this penalty on a case-by-case basis "if the payee described in section 4974(a) establishes to the satisfaction of the Commissioner" that "(1) The shortfall...in the amount distributed in any taxable year was due to reasonable error; and (2) Reasonable steps are being taken to remedy the shortfall."
If you missed one or more RMDs either partially or completely, and you believe there was reasonable cause for that error, here are the steps to take to request the waiver.
Unlike with requests for waiver of the 60-day deadline for rollovers, penalty-waivers do not require a private letter ruling from the IRS. That is good news (there is no filing fee for requesting a waiver of the RMD penalty) and bad news (there is almost no published record of what the IRS considers to be "reasonable error" with respect to this penalty).
Based on anecdotal evidence, serious illness, mental incapacity, and financial-institution error have been accepted as reasonable causes for missing the RMD. In a rare PLR discussing this subject, the IRS ruled that beneficiaries who failed to take RMDs from an inherited IRA had reasonable cause for their failure (and therefore did not owe any penalty) because the IRA had been impounded and frozen by a state court pending the outcome of litigation over who was entitled to the account.
Prepare and file Form 5329 for each year in which there was a shortfall. If the income tax return for that year has not yet been filed, Form 5329 can be attached to the income tax return. For years for which the income tax return has already been filed, file each year's 5329 as a separate stand-alone return.
Take the missed RMD as soon as possible. To compute the amount that must be taken as a "catchup" distribution, there are two approaches. IRS regulations contain a formula for computing the adjusted year-end balance and adjusted RMD catchup amount, to reflect earnings and losses that have occurred since the year the RMD should have been taken. Use of that method, though complicated, should certainly be accepted by the IRS. In simple cases, however, just computing the (unadjusted) RMD amount based on the (unadjusted) prior year-end balances has also proven effective.
Though not legally required, I recommend taking a separate withdrawal check for each year that the RMD was missed, that the check not be combined with any other distribution, and that the investor not have any taxes withheld from his "shortfall" check. That way, there will be a nice clean separate check for the exact amount of each year's missed distribution; make a copy of that check to attach to Form 5329, then deposit the check in a taxable bank account.
The distribution amount will be included in the investor's income for the year he actually takes it, not for the prior year when it should have been taken. So there is no need to file amended income tax returns for prior years. Once the year has ended, there is no way to go back and retroactively include the income created by this missed distribution in the prior year.
The investor does not have to pay the penalty as a precondition of requesting the waiver; that requirement, which appeared in pre-2005 editions of the IRS instructions, no longer appears anywhere.
Most important: Complete Part VIII of the Form 5329 ("Additional Tax on Excess Accumulation in Qualified Retirement Plans (Including IRAs)") as follows:
- On line 50, enter the amount of the required minimum distributions that were supposed to have been taken during that particular year.
- On line 51, enter the total of distributions actually taken during the applicable year.
- On line 52, enter "zero," and write "RC" in the margin. Do not enter the amount of the shortfall! Even though it appears that you should enter on this line the amount the investor failed to take, you are supposed to put zero on this line if you are requesting a waiver of the penalty! If you put any dollar amount on this line, the IRS computers will automatically assess the penalty and start sending you dunning notices.
- On line 53 (amount of penalty), enter zero.
- Attach a statement to the Form 5329 indicating the reasonable cause and also verifying that you have "remedied the shortfall" (attach a photocopy of the "shortfall check").
File this package with a cover letter listing what is being filed. If the IRS accepts the excuse as a reasonable error, you should receive notice from the IRS in a few months, indicating it is accepting the return as filed. (If Form 5329 is attached to an income tax return, then you will not receive a notification regarding the return being accepted.) If they don't buy your reasonable error, you'll get a bill!
Where to read more: For explanation of required minimum distributions see § 401(a)(9) of the Code, and Treasury regulations thereunder, and Chapter 1 of Life and Death Planning for Retirement Benefits. Regarding the penalty, see § 4974(a) of the Internal Revenue Code. Regarding the waiver procedure, see § 4974(d), Reg. § 54.4974-2, A-7(a), IRS Publication 590-B (2014 returns edition), p. 27, and instructions for IRS Form 5329. For discussion of this and other IRA problems and how to fix them, see Natalie Choate's Special Report: IRAs with Hair, downloadable at http://www.ataxplan.com/.
Now available in electronic edition! By popular demand, Natalie Choate's book Life and Death Planning for Retirement Benefits has been published in an electronic version. The e-book edition gives you the entire book in word-searchable format, PLUS two additional chapters (on life insurance and annuities in retirement plans) that were left out of the print edition for reasons of space. Updates for the new 2015 rollover rules are already incorporated into the e-book. And of course the convenience you expect from an electronic format: Word-searchable text, live links to cross-referenced book sections and most cited tax sources, and access anywhere you have an internet connection. Only $9 per month, cancellable at any time. Visit www.retirementbenefitsplanning.com to subscribe or learn more.