Ian Berger, JD
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In the June 16, 2021 Slott Report, we discussed how an in-service distribution made in the year of separation from service can inadvertently create an excess IRA contribution if that distribution is rolled over when a required minimum distributions (RMD) is due. A related issue is how rollovers and transfers from 401(k) plans (or other company plans) and IRAs are treated differently when an RMD is required.
If you do a 60-day rollover from an IRA (that is, the distribution is paid directly to you) in a year when an RMD is due, the RMD is required to come out first. That’s because RMDs are not eligible for rollover. The same rule applies to 60-day rollovers from 401(k)s. If you mistakenly roll over all or a portion of an RMD from either an IRA or a plan, the rolled over RMD is considered an excess IRA contribution. You will then be subject to an annual 6% penalty unless you withdraw the excess amount (the RMD), plus any earnings attributable to it, by October 15 of the following year.
However, if you do a direct (trustee-to-trustee) transfer (that is, the funds are paid directly to another custodian) instead of a 60-day rollover, the rules are different for IRAs and plans. If the transfer is from an IRA, the RMD does not have to be distributed before the remaining amount can be transferred. But you would still have to remember to take the RMD by the end of the year from the new IRA. If you forget, you could be hit with a 50% excise tax on the unpaid RMD – although the IRS will often waive that penalty.
You do not have the same flexibility with an RMD if the direct transfer is made from a company plan. In the eyes of the IRS, a company plan transfer is a distribution and then a rollover. Repeat after me: RMDs can’t be rolled over. So, whether it’s a 60-day rollover or a direct transfer from a plan, the RMD must be paid first.
Another source of confusion concerns the due date of the first RMD when rolling over 401(k) funds. Usually, you can defer your first RMD to April 1 of the following year. (However, that means you will have two taxable RMDs in that following year.)
But what if you retire in the year you first become subject to RMDs and want to do a transfer or rollover from your 401(k) that same year? Unfortunately, if you proceed with the transfer or rollover, you cannot defer the first RMD until the next year. The only way to delay the first RMD would be to also delay your 401(k) rollover or transfer until a subsequent year. If you put off your 401(k) rollover or transfer until the very next year, both of your first two RMDs must come out before you can do the rollover or transfer.
Keep in mind that the rules in the preceding paragraph also apply if you use the “still-working exception” to delay your first RMD until the year of retirement beyond age 72.