Retirement savings vehicles like 401(k)s, 403(b)s, and traditional individual retirement accounts (IRAs) provide dual benefits for savers. They allow individuals to build a nest egg for their retirement years while simultaneously offering tax advantages during the saving phase. Typically, the tax benefit is provided upfront in the form of deductions from taxable income when contributions are made to these accounts, thereby lowering an individual’s tax liability for the year of contribution.
However, these tax-advantaged accounts have rules governing the withdrawal phase, namely the obligation to take required minimum distributions (RMDs). Starting the calendar year an individual reaches the age of 73, the Internal Revenue Service (IRS) mandates that participants begin withdrawing a minimum amount from these retirement accounts annually. This requirement ensures that tax-deferred retirement accounts eventually generate taxable income as intended.
Noncompliance with RMD rules carries a substantial cost. Specifically, the IRS imposes a penalty amounting to 25% of the RMD amount that was not taken. To illustrate, if an individual was scheduled to withdraw $30,000 from their retirement account in a given year but only withdrew $10,000, the shortfall of $20,000 subjects them to a $5,000 penalty (which is 25% of $20,000). This penalty is a significant deterrent to neglecting RMD obligations.
Despite the severity of the penalty, there are remedies available to those who inadvertently miss taking their RMDs. Individuals who take corrective action within two years of the missed distribution may qualify to reduce the penalty from 25% to 10%. For example, in the prior scenario, timely correction could lower the monetary penalty from $5,000 to $2,000, a reduction of more than half.
The IRS provides two programs to address missed RMDs: the Self-Correction Program (SCP) and the Voluntary Correction Program (VCP).
- Self-Correction Program (SCP): This avenue allows individuals to correct the missed distribution independently without needing to notify or engage directly with the IRS. By simply withdrawing the appropriate amount post-mistake, the individual can rectify the oversight. It is important to note, however, that utilizing the SCP does not grant a waiver on penalties. The full 25% penalty on the missed amount still applies.
- Voluntary Correction Program (VCP): This more formal procedure involves submitting a request to the IRS to waive or reduce penalties associated with the missed RMD. Achieving a penalty waiver under the VCP requires filing Form 14568-H. This option is applicable for cases where the individual believes they have a reasonable cause for missing the withdrawal.
For example, if a person failed to take an RMD from a traditional IRA, they would need to make the missed withdrawal as soon as possible and file IRS Form 5329, seeking a “reasonable cause” waiver. Accompanying this form, the individual must provide a detailed letter explaining the circumstances behind the missed RMD. The IRS interprets “reasonable cause” on a case-by-case basis. Acceptable reasons often include medical emergencies, issues with financial institutions that prevented timely withdrawal, or significant events such as the death of an immediate family member.
It is crucial to recognize that while these remedial measures exist, the IRS maintains discretion over approving penalty reductions or waivers. Therefore, individuals must act promptly and ensure all necessary documentation and explanations meet IRS standards for “reasonable cause” in order to improve their chances of penalty mitigation.
In summary, mandated required minimum distributions from tax-advantaged retirement accounts are designed to transition deferred tax benefits into taxable income during retirement. Failure to comply triggers significant penalties. Nevertheless, pathways are available to rectify missed RMDs and potentially alleviate penalty burdens. Retirees should remain vigilant regarding RMD schedules and act swiftly if omissions occur to minimize financial repercussions.