Minimum Distribution Problems—Why Most Retirement Plans Have Them and What Can Be Done About It
The minimum distribution requirements of Internal Revenue Code Section 401(a)(9) generally require that retirement plan participants withdraw at least a small portion of their account balances by April 1st of the year in which they turn 70½ or retire. However, this is an exceedingly difficult requirement for retirement plans to satisfy. In fact, few of the plans we have worked with have had a completely clean track record of doing so.
One of the reasons that the minimum distribution requirement is so difficult to satisfy is that many plan sponsors incorrectly assume that participants will withdraw some of their account balance when they retire due to the need for income replacement; therefore, they do not focus on enforcement. While assuming retirees will use the money in their account is logical, some do not, and therefore the plan is not in compliance with the requirement.
Additionally, the Required Minimum Distribution (RMD) rules are quite complicated, especially for those less versed in retirement plan jargon, like typical retirees. Thus, many RMDs are not taken by plan participants due to confusion over the rules and the withdrawal process, which can also be complicated.
Retirees of today are less likely to have been with the same employer throughout their entire working career, resulting in multiple retirement plan account balances to navigate and the possibility of forgetting about those balances come retirement age. While many retirees manage to take their RMDs from account balances of the employer from which they retire, it is less likely that they will remember to do so from the employer at which they worked in their 20s.
The penalty for participants who do not take their RMDs can be severe. The IRS can assess a penalty of 50 percent to the missed distribution amount. Fortunately, the penalty can be waived if the participant files a special tax form with an explanation.
For plan sponsors, if the IRS discovers an RMD violation upon audit, the consequences are equally – or even more – daunting. A pattern of failure to execute timely RMDs is one of the few plan defects that can disqualify an entire retirement plan, rendering each and every account balance in that plan immediately taxable to plan participants! Fortunately, the IRS does not often turn to disqualification, but they can make the life of a plan sponsor extremely unpleasant if RMD failures are discovered.
What Can Plan Sponsors Do?
Fortunately, there are some simple solutions that plan sponsors can implement to protect themselves and their participants.
Plan sponsors should carefully review a list of current and former employees to determine who has not taken their RMDs; the plan’s recordkeeper can help produce this report. For 403(b) plan sponsors, there is technically an exception that allows employees who have not taken an RMD from their 403(b) plan to satisfy the obligation from another 403(b) plan; however, do to the complexity, this is an unlikely scenario. Therefore, plan sponsors should assume that any employee who has not taken an RMD from their plan (403(b) or otherwise) is out of compliance. Plan sponsors should then work with their recordkeeper to contact those individuals and remind them of the associated penalty for satisfying the RMD.
If a plan sponsor is unable to make contact with the individuals, the retirement plan should be amended to state that RMDs will be automatically distributed to employees who do not respond within a certain timeframe. This requires collaboration with your recordkeeper, as some are not equipped to make distributions without participant consent. However, when pressed, the majority of recordkeepers will honor the plan document and the plan sponsor’s direction.
Additionally, it is important that plan sponsors stay up-to-date with the addresses of former employees, as implementing automatic distributions will be relatively meaningless if a participant’s check is returned due to an incorrect address. For information on how to ensure that certain retirees (and other former employees) do not go missing, please review this Top of Mind blog post.
Another solution for plan sponsors is to educate employees nearing retirement of their RMD obligations before they retire. Explaining that the entire retirement plan account balance cannot be left to their heirs and that a small amount (which their recordkeeper can calculate) must be taken may help avoid future RMD issues.
Due to the significant consequences of failing to fulfil the IRS’ minimum distribution requirements, it is important for plan sponsors to fully understand the rules and educate their participants appropriately. Doing so can avoid costly mistakes for both plan sponsors and participants alike.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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