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SMART INSIGHTS FROM PROFESSIONAL ADVISERS

Avoiding the 50% Penalty on Overlooked RMDs

You're busy enjoying retirement and you just plain forget to take your required minimum distribution. Or you do the math wrong. It could be a costly mistake. Here's how to fix it.

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There’s no denying the tax benefits of funding a retirement account, one of which is the compound effect of tax-deferred growth. But your money can’t avoid the IRS forever.

SEE ALSO: Avoid Mistakes and Penalties with the ABCs of RMDs

That’s why owners and beneficiaries of traditional IRAs, SEP and SIMPLE IRAs, 401(k)s and 403(b) accounts must meet the deadline for taking their required minimum distributions (RMD), which kick in once they reach the age of 70½.

Where People Go Wrong

All too often, owners of these plans make a costly mistake: They either end up miscalculating their RMD, or they take it from the wrong type of account. For example they may erroneously take a distribution from the other spouse's IRA.

There's more than a good chance that some retirement account owners will fail to properly take all of their required distributions. When an RMD is not correctly taken, any shortfall is subject to a 50% penalty. To put that in dollar figures, if you had an IRA worth $200,000 and you were 72 years old, your RMD would be approximately $7,813. If you somehow missed taking that required distribution you could owe the IRS a penalty of $3,907.

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How to Fix Your Error

However, if you catch your mistake sooner rather than later and promptly take the proper action, this is one penalty you can usually avoid. The IRS has the authority to waive the 50% RMD penalty when the shortfall is due to a reasonable error.

Step 1

The first thing you should do after discovering your RMD was missed or you didn’t take the right amount is to take immediate corrective action. Calculate the shortfall and then remove that amount as soon as possible from the IRA. (For help on how to do the math, try an RMD calculator.)

Step 2

Next, file tax form 5329, "Additional Taxes on Qualified Plans (Including IRAs) And Other Tax Favored Accounts." This form can be filed with your tax return or by itself. As long as you're requesting that the 50% penalty be waived, payment does not have to be made when the forms are filed.

Step 3

Along with the form 5329, you should attach a letter explaining the shortfall and the steps taken to rectify the error.

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In addition, provide an explanation as to why you made the mistake in the first place. While there's no formal guidance on what a "reasonable error" is, some potential explanations that might pass IRS scrutiny include: illness, a death in the family, a change in address that disrupted essential communication regarding the RMD, or that you relied upon incorrect professional advice.

While there's no guarantee, if you follow these steps, there’s a good chance the IRS will waive the penalty. If so, you can expect to receive a notice from the IRS a few months after submitting the form 5329 confirming that they have waived the penalty. It’s a good idea to save this notice.

See Also: Is $1 Million Enough to Retire?

To Avoid Problems in the Future

Missing your RMD can be frustrating and costly. To ensure it does not happen again, take the necessary steps to make sure the correct distribution occurs by the applicable deadline.

This includes making arrangements with your custodian for systematic or automatic withdrawals to occur on a predetermined date. Submit your withdrawal request at least two months before the deadline, and check your statements to ensure the correct amount was distributed from your account.

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Submitting your requests early allows sufficient time for any necessary adjustments. Finally, talk to your financial institution about other ways it can help you satisfy your RMD requirements.

Good luck, and next year at a minimum, be sure to double-check your required minimum distribution calculations.

See Also: Everything You Need to Know About RMDs

Mike Piershale, ChFC, is president of Piershale Financial Group in Barrington, Illinois. He works directly with clients on retirement and estate planning, portfolio management and insurance needs.

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