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Year-end planning: withdraw required minimum distributions before year-end to avoid penalty

As the final quarter of the year approaches, older taxpayers need to keep a careful eye on their required minimum distributions (RMDs) for the year, as a stiff penalty applies to those who don’t withdraw enough from their retirement accounts. This article explains the rules that apply and offers a strategy for those older taxpayers who would be interested in using the qualified charitable contribution deduction this year, should it be retroactively reinstated by Congress.

Take the RMD or pay a big penalty. Taxpayers must start taking annual RMDs from their traditional IRAs by April 1 following the year in which they attain age 70 1/2. As for qualified plans (e.g., 401(k)s), 5% owners are subject to the same rules as apply for IRA owners. However, for a non-5% owner, RMDs may commence by April 1 of the year following the later of the year in which the taxpayer (a) reaches age 70 1/2, or (b) retires. (Code Sec. 401(a)(9), Code Sec. 408(a)(6)) Failure to withdraw the annual RMD could expose the taxpayer to a penalty tax equal to 50% of the excess of the amount that should have been withdrawn over the amount that actually was withdrawn. (Code Sec. 4974)

The amount of each RMD is calculated separately for each IRA. However, the RMD amounts for the separate IRAs may be totaled and the aggregated RMD amount may be paid out from any one or more of the IRA accounts. (Reg. § 1.408-8, Q&A 9)

RIA illustration Jim has two separate traditional IRAs. The RMD from IRA-A is $6,000, and the RMD from IRA-B is $4,000. He may take his total $10,000 RMD from either IRA-A or IRA-B, or take distributions from both, as long as the total IRA payout for the year is $10,000.
RIA observation: This rule gives flexibility to owners of multiple IRAs. For example, if an IRA is invested in stocks or mutual fund shares whose price currently is depressed, the minimum distribution can be made from another IRA invested in a fund showing gains to avoid selling at a market low and losing future appreciation potential.
RIA caution: Many financial institutions automatically place each year’s RMD in a separate non-IRA account. This procedure avoids the risk of penalties for insufficient distributions. A taxpayer who wants to take his RMD from another IRA should notify the trustees or custodians of the IRAs from which he does not want to withdraw to avoid potentially having an amount be automatically withdrawn from them.

The rule permitting amounts in traditional IRAs to be aggregated for RMD purposes applies only to IRAs that an individual holds as an owner. It doesn’t apply to IRAs that an individual holds as a beneficiary. IRAs held by a person as a beneficiary of the same decedent may be aggregated, but can’t be aggregated with amounts held in IRAs that the individual holds as the IRA owner or as the beneficiary of another decedent. And no traditional IRA can be aggregated with a qualified retirement plan account or a Roth IRA to determine payouts. (Reg. § 1.408-8, Q&A 9) Additionally, RMDs must be calculated separately for each qualified plan account and paid separately. (Reg. § 1.401(a)(9)-5, Q&A 1, Q&A 3.)

RMD strategy for dealing with possible revival of qualified charitable contributions. For pre-2014 distributions, an annual exclusion from gross income (not to exceed $100,000) was available for otherwise taxable IRA distributions that were qualified charitable distributions. (Code Sec. 408(D)(8)) Such distributions weren’t subject to the general percentage limitations that apply for making charitable contributions since they weren’t included in gross income and couldn’t be claimed as a deduction on the taxpayer’s return. Since a qualified charitable distribution wasn’t includible in gross income, it didn’t increase AGI for purposes of the phaseout of any deduction, exclusion, or tax credit that is limited or lost completely when AGI reaches certain specified levels.

To constitute a qualified charitable distribution, the distribution had to be made (1) after the IRA owner attained age 70 1/2 and (2) directly by the IRA trustee to a Code Sec. 170(b)(1)(A) charitable organization (other than a Code Sec. 509(a)(3) organization or a donor advised fund (as defined in Code Sec. 4966(d)(2)). Also, to be excludible from gross income, the distribution had to be otherwise entirely deductible as a charitable contribution deduction under Code Sec. 170 without regard to the regular charitable deduction percentage limits.

RIA observation: There’s reason to be optimistic that the charitable contribution deduction will be revived, since it has been retroactively extended several times before. Code Sec. 408(d)(8) was first enacted by the Pension Protection Act of 2006 (P.L. 109-280). It expired on Dec. 31, 2007 but was retroactively revived and extended through 2009. After it expired on Dec. 31, 2009, it was retroactively revived and extended through 2011. After expiring on Dec. 31, 2011, Code Sec. 408(d)(8) was retroactively reinstated and extended through 2013.

The charitable contribution deduction was a preferred strategy for taxpayers who didn’t want to withdraw money from their IRAs but had to do so anyway because of the RMD rules. The reason for this is that even though a direct distribution from an IRA to a charity was not included in the taxpayer’s gross income, it was taken into account in determining the owner’s RMD for the year.

RIA recommendation: Taxpayers who would benefit this year from taking charitable contribution deductions (if they were available) instead of RMDs, should consider deferring their RMD for 2014 until near the end of the year. Thus, if (a) the charitable contribution deduction is revived for 2014 before the end of this year, and (b) any amount distributed directly from a taxpayer’s IRA to an eligible charity during 2014 at least equals the amount of his RMD for the tax year, the taxpayer will not be required to take any other 2014 distribution from the IRA.