There's 1 tax mistake that can trigger a 50% penalty, and Baby Boomers are most likely to be hit with the penalty
Share to linkedinThere’s one tax mistake that can trigger a 50% penalty. I think it’s the steepest in the tax code. Of course, you might owe interest on top of that penalty. The mistake is to fail to take at least the required minimum distribution from a qualified retirement plan, which includes IRAs and 401s.
The penalty is 50% of the amount that you should have distributed but failed to. To make the situation worse, the RMD rules have changed several times over the last few decades and never have been clear or intuitive. Not surprisingly, a few years ago the IRS realized many taxpayers weren’t taking the correct RMDs. So the IRS changed its systems so it could readily identify these taxpayers. The Setting Every Community Up for Retirement Enhancement Act, signed into law by President Trump on December 20, 2019, makes an important change in RMDs. In the past, RMDs had to begin after a person turned age 70½. That was the rule for many years despite increasing life expectancies and the confusion that the half year caused. The SECURE changed the start date to age 72. The change in the SECURE Act applies only to IRA owners who turned 70½ after December 31, 2019. If you were 70½ by the end of 2019 you are subject to the old rules and must take your first RMD by April 1, 2020, if you didn’t take it in 2019. If you turn 70 1/2 after 2019, your first RMD is due no later than April 1 of the year after you turn 72.Misunderstanding an exception. Some people don’t have to take RMDs after age 70½, but the exception is limited and can be confusing. The most confusing part is that the exception applies to some types of plans but not to others. Someone who still is working at age 70½ doesn’t have to take RMDs from the employer’s retirement plan, if the individual is not a 5% or greater owner of the business. But the exception doesn’t apply to IRA RMDs, only to an employment retirement plan such as a 401. The exception also applies only to plans of the employer for whom you’re working at the time. Any accounts you have at past employers are subject to RMDs.You might plan to convert a traditional retirement account to a Roth account or roll over a 401 plan to an IRA. You can do either transaction. But if you’re required to take an RMD that year, you have to take the RMD first and do your planned transaction with the rest of the account. The most common mistake is for someone to convert a traditional IRA to a Roth IRA and believe the rollover includes the RMD. You have to take the RMD first and include it in gross income. Then, you can convert any remaining amount in the traditional IRA to a Roth IRA. The RMD amount can’t be rolled over to the Roth IRA. You might be able to contribute the RMD amount to the Roth IRA, because you’re allowed to make Roth IRA contributions after age 70½. But you must have earned income at least equal to the amount of the contribution. Also, in 2019 your adjusted gross income couldn’t be above $122,000 if you’re single or $193,000 for married couples filing jointly.An RMD from a traditional IRA or 401 has to be included in your gross income for the year. You can’t avoid taxes by rolling over the RMD amount into either a traditional IRA or an employer retirement plan. In fact, until the SECURE Act you weren’t allowed to make contributions to a traditional IRA after age 70½. But your IRA contributions still are limited to your earned income for the year. If you are retired and don’t have earned income, you can’t contribute to an IRA.When you own multiple traditional IRAs, you can aggregate the RMDs and take the total from the IRAs in any proportion you want. But RMDs can’t be aggregated for most other types of retirement plans. The RMD must be computed and taken separately from each account. When in doubt, don’t aggregate.One of the more confusing features of our tax code is that sometimes married couples are treated as one unit and sometimes they are treated as separate taxpayers.Each spouse separately must compute the RMDs for his or her IRAs and employer accounts. Then, the RMDs must be taken from that spouse’s accounts. There’s no merging, combining or linking the accounts of the spouses.
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