All retirement account owners must be familiar with the required minimum distribution (“RMD”) rules applicable to their accounts. These rules require you, in most instances, to take partial distributions from your retirement account when you reach age 70 ½. And, surprise, the rules for Traditional IRAs, Roth IRAs, and 401(k)s differ. In fact, even 401(k)s where you are a 5% or greater owner have different rules than 401(k)s where you aren’t an owner. Thanks, Congress.
So what rules apply to Solo 401(k) owners? Well, generally speaking, you must begin taking distributions from your Solo K when you reach age 70 ½. Despite what you may think or presume, there are three quirks to be aware of when it comes to RMD and Solo 401(k):
Still Working Exception Does Not Work on Solo Ks
There is a general RMD 401(k) rule which states that even after age 70 ½, you are not required to take distributions from an employer 401(k) when you are still working for that employer. However, this exception does not apply to account holders or their spouses who own 5% or more of the company. In other words, business owners who use a Solo 401(k) will be forced to take RMD from their Solo 401(k) after age 70 ½ even if they are still working in the business.
Roth 401(k) Funds are Subject to RMD
RMD applies to Roth 401(k)s. I know what you’re thinking, “Wait, but why would RMDs apply to Roth 401(k)s when Roth IRAs are exempt?” Because Congress said so. I know, it doesn’t make much sense, Roth 401(k) distributions at retirement will be tax-free, like Roth IRA distributions, and the IRS will not receive any revenue from the distribution so why treat Roth 401(k)’s differently? There’s not a good answer, but you should write your Congressperson or Senator and ask. In the meantime, if you’re 70 ½ and you have funds in a Roth 401(k) which you don’t want distributed, you can roll those Roth 401(k) funds out to a Roth IRA and you can avoid the distribution requirement by letting those funds sit in your Roth IRA where no RMD is required. Checkmate, IRS.
Every 401(k) Must Have RMD Taken, No Aggregating
Every 401(k) account you have must take RMD. So, for example, if you have a Solo 401(k) and a 401(k) account with an old employer then you need to take RMD from each 401(k) account. You cannot aggregate those accounts together and take RMD out of one to satisfy both RMD requirements. This aggregating is allowed in Traditional IRAs but unfortunately does not work with different 401(k) plan accounts. If taking RMDs from multiple accounts is getting too complex, you can roll the old employer 401(k) to the Solo K or to a Traditional IRA (or Roth IRA if Roth 401(k) funds) to consolidate your accounts and your RMD requirements.
Make sure take RMD when you are required to do so. Failure to take RMD results in a 50% penalty tax on the amount you failed to take. As a result, it’s critical that you understand the RMD rules for each retirement account you hold. If you have made a mistake though, the IRS does have penalty waiver programs whereby you can correct some failed RMDs and request a waiver of the penalty due. This doesn’t work in every instance, but if you’ve failed to take RMD ask your tax lawyer or accountant on whether a penalty waiver could apply in your instance.
Do you have tuition or other college expenses due for yourself, your spouse, or your child? Would you like to use your IRA to pay for these expenses? Would you like to avoid the 10% early withdrawal penalty for accessing your IRA funds before you are age 59 ½? This article outlines how you can avoid the 10% early withdrawal penalty when using your IRA to pay for higher education expenses.
Whether you should actually take a distribution from your IRA to pay for the higher education expenses of your child is another topic. Sadly, too many parents have raided their own retirement savings to pay for their children’s college education expenses. They then reach retirement age with a sliver of what savings or retirement accounts they could’ve otherwise relied on. Everyone’s situation and goals are unique but if you have decided to use IRA funds to help pay for educational expenses here’s how you can avoid the 10% penalty for accessing your own money.
10% Penalty Exception Rules for Higher Education Expenses
Here’s a quick breakdown on how the 10% withdrawal penalty can be avoided when you use IRA funds to pay for qualifying higher education expenses.
1. Who can the IRA money be used for?
Your IRA funds may be used for qualifying higher education expenses of the IRA owner, their spouse, children, and their descendants.
2. What schools qualify?
Any school eligible to participate in federal student aid programs qualifies. This would include public and private colleges as well as vocational schools. Any school where you, your spouse, or your child completed a FAFSA application will qualify.
3. What expenses qualify?
There is a broad list of qualifying expenses. These include tuition, fees, books, supplies, and equipment. Also, room and board is included if the student is enrolled at least halftime.
4. How much is exempt?
The amount of your distribution that is exempt from tax is computed in three steps. First, determine the total qualifying expenses (tuition, fees, books, room and board, etc.) Second, reduce the qualifying expenses by any tax-free education expenses. These include Coverdell IRA distributions, federal grants (e.g. Pell grants), and any veterans or employer assistance received. Third, subtract and tax-free education assistance from the total qualifying expenses incurred and this gives you the total qualifying amount that you may take an early withdrawal from your IRA and avoid the 10% penalty.
Here’s a quick example to illustrate theses rules: You’re age 53 and have an IRA you’d like to access to help cover your daughter’s education expenses. Your daughter Jane is attending Harrison University, a private college that participates in federal student aid programs.
Her expenses for the year are as follows:
- Tuition: $22,000
- Room and Board: $13,000
- Books: $1,000
- Supplies: $500
- Equipment: $500
- Total Qualifying Expenses: $37,000
Jane received the following aid:
- Federal Grant: $2,400
- Coverdell IRA Payment: $5,000
- Federal Student Loan: $10,500 (loans do not reduce the qualifying expenses)
- Total Tax-Free Assistance: $7,400
- Total Amount Eligible for a Penalty-Free 10% Early Withdrawal: $29,600
You decide to take a $10,000 withdrawal from your IRA. Since the total amount eligible is $29,600, the entire distribution will be penalty-free. Keep in mind that while the $10,000 distribution is penalty-free it is still included into the taxable income of the IRA owner.
For more details on the 10% early withdrawal exception for higher education expenses, refer to IRS Publication 970. Also, the above example presumes the IRA owner has a traditional IRA. If the IRA owner has a Roth IRA, there are different considerations and distribution rules.
Many investors and financial professionals are familiar with the primary benefits of a Roth IRA: that the plans investments grow tax-free and come out tax-free. But if tax-free investing isn’t enough to get you excited, rest assured, there are more benefits to the Roth IRA. I’ll note just three more in this article.
Remember, Roth IRAs are for nearly everyone with earned income. They’re not restricted to high income earners. Check out my prior article here if you’re unfamiliar with the back-door Roth IRA. Okay, now lets over the other perks of Roth IRAs.
No Required Minimum Distributions
First, Roth IRAs are not subject to RMD. Traditional retirement plan owners are subject to rules known as Required Minimum Distribution rules which require the account owner to start taking distributions and paying tax on the distributions (since traditional plan) when the account owner reaches the age of 70 ½. Not being subject to RMD rules allows the Roth IRA to keep accumulating tax free income (free of capital gain or other taxes on its investment returns) and allows the account to continue to accumulate tax free income during the account owner’s life time. Learn more about the facts and fiction about IRA RMDs here.
Spousal Rollover: The Best Asset to Leave to Your Spouse
Second, a surviving spouse who is the beneficiary of a Roth IRA can continue contributing to that Roth IRA or can combine that Roth IRA into their own Roth IRA. Allowing the spouse beneficiary to take over the account allows additional tax free growth on investments in the Roth IRA account. Non spouse beneficiaries (e.g. children of Roth IRA owner) cannot make additional contributions to the inherited Roth IRA and cannot combine it with their own Roth IRA account. The non-spouse beneficiary becomes subject to required minimum distribution rules but can delay out required distributions up to 5 years from the year of the Roth IRA account owner’s death and is able to continue to keep the tax free return treatment of the retirement account for 5 years after the death of the owner. The second option for non-spouse beneficiaries is to take withdrawals of the account over the life time expectancy of the beneficiary (the younger the beneficiary the longer they can delay taking money out of the Roth IRA). The lifetime expectancy option is usually the best option for a non-spouse beneficiary to keep as much money in the Roth IRA for tax free returns and growth.
Tax and Penalty Free Withdrawals Before Age 59 ½ On What You Put In
Third, Roth IRA owners are not subject to the 10% early withdrawal penalty for distributions they take before age 59 ½ on amounts that are comprised of contributions or conversions. Growth and earning are subject to the early withdrawal penalty and taxes too, but you can always take out the amounts you contributed to your Roth IRA or the amounts that you converted without paying taxes or penalties (note that conversions have a 5 year wait period before you can take out funds penalty and tax free). This makes the Roth IRA the most powerful savings account out there because you can take out what you put in without penalty or tax for whatever reason you may have as hardship is not required. Traditional IRAs have no such benefits.
Roth IRAs are a great tool for many investors. Keep in mind that there are qualification rules to being eligible for a Roth IRA that leave out many high income individuals. However, you can convert your traditional retirement plan dollars to a Roth IRA (sometimes known as a backdoor Roth IRA) as the conversion rules do not have an income qualification level requirement on converted amounts to Roth IRAs. This conversion option has in essence made Roth IRAs available to everyone regardless of income.
Distributions from a 401(k) to its owner are subject to a 20% withholding tax whereas distributions from an IRA are not subject to a withholding tax. As a result, any amounts distributed from a 401(k) to its owner will be reduced by 20% and that 20% will be sent to the IRS in expectation of the taxes that will be due from the account owner for the distribution. Any amounts distributed from an IRA, however, are not subject to the 20% withholding as the IRA owner can elect out of withholding. The discrepancy in the rules is one advantage of using an IRA in retirement as opposed to a 401(k) since the amounts distributed from the IRA can be received in their entirely. Keep in mind, the tax owed on a distribution from an IRA or 401(k) is the exact same. The difference is when you are required to pay it. In both instances you will receive a 1099-R from your custodian/administrator but in the 401(k) distribution you are required to set aside and effectively pre-pay the taxes owed.
The 401(k) Withholding Rule in Practice
Let’s walk though a common situation that outlines the issue. Sarah is 64 and has a 401(k). She would like to distribute $100,000 from the 401(k). She contacts her 401(k) administrator and is told that on a $100,000 distribution they will send her $80,000 and that $20,000 will be sent to the IRS for her to cover the 20% withholding requirement. Since this 20% withholding requirement does not apply to IRAs, Sarah decides to roll/transfer the $100,000 from her 401(k) directly to an IRA. Once the funds arrive at the IRA, Sarah takes the $100,000 distribution from the IRA and there is no mandatory 20% withholding so she actually receives $100,000 in total. Keep in mind, Sarah will still owe taxes on the $100,000 distribution from the IRA and she will receive a 1099-R to include on her tax return. That being said. Sarah has given herself the ability to access all of the amounts distributed for her retirement account without the need for sending withholding to the IRS at the time of distribution.
It’s that simple. Don’t take distributions from a 401(k) and subject yourself to the 20% withholding tax when you can roll/transfer those 401(k) funds to an IRA and receive the entire distribution desired without a 20% withholding.
When a retiree begins taking distributions from a traditional IRA, 401(k), or pension plan, those distributions are taxable to the retiree under federal income tax and any applicable state income tax rules. While federal taxation cannot be avoided, state taxation may be avoided depending on your state of residency. In general, there are some states that have zero income tax and therefore don’t tax retirement plan distributions, some states that have special exemptions for retirement plan distributions, and other states that do in fact tax retirement plan distributions. This article breaks down the basics and discusses some of the states where income taxes can be avoided.
The No State Income Tax States
First, the easiest way to avoid state income tax on retirement plan distributions is to establish residency in a state that has no state income tax. It isn’t just the fun and sun of Florida that helps attract all of those retirees. It’s the tax free state income treatment that you’ll get from all of that money stocked away in your retirement account. The other states with no income tax and therefore no tax on retirement plan distributions are Alaska, Nevada, South Dakota, Texas, Washington, and Wyoming.
States with Retirement Income Exclusions
Second, there are some states that have a state income tax but who exempt retirement plan distributions for retirees from state income taxes. There are 36 states in this category that have some sort of exemption for retirement plan distributions. As each of these states are very different, so too are their exemptions. The type of retirement account, however, does tend to govern the exemptions available. Here’s a quick summary of the common exemptions found in the states.
- For Public Pensions and Retirement Plans. Distributions from federal or state employer plans are exempt from taxation in many states. This is the most common exemption amongst states that have an income tax but who exempt some types of retirement plan distributions from income. Most of the 36 states that have an exemption for retirement plan income provide an exemption for public employee pensions and retirement plans.
- For Private Pensions and Retirement Plans. About 10 states offer a full exclusion for private pensions and retirement plans. Some of them differ between pension and contributory plans (e.g. 401(k)) and some of them make no distinction. Pennsylvania, for example, excludes all income distributions. Hawaii excludes certain distributions from state income tax for private retirement plans and for portions from company plans rolled over to a rollover IRA and then distributed from the rollover IRA.
- For IRAs. There are some states that do no tax any retirement pan distributions, including IRA distributions to retirees. Illinois for example does not tax distributions from retirement plans at all (pensions, IRAs, 401(k) s). Tennessee and New Hampshire are states that do not tax wage income and therefore they do not tax retirement plan distributions of any kind (IRA, 401(k), etc.). There are also numerous states that exclude a certain limit of retirement plan income from taxation. For example, Main exempts the first $10,000 of income from any retirement plan, including IRAs.
In sum, the state tax rules for retirement plan distributions are complicated and vary significantly. Each state can be understood rather quickly though and everyone planning for retirement should understand how state income taxes may eat into their planned retirement plan distributions. I, for example, looked into Arizona and found that there is no exemption for 401(k) or IRA income in the state of Arizona. While we do have a low state income tax rate, Arizona state income tax includes income from private retirement plans (pensions and 401(k) s) and IRAs and has a modest deduction for distributions from public retirement plans. Each state is unique to the type of plan, and the amounts being distributed but don’t just think you need to be in a state with zero income tax to avoid taxes on retirement plan distributions. For example, you could be in Illinois, Tennessee, or New Hampshire and could realize state income tax-free distributions of your IRA or 401(k). The National Conference of State Legislators has an updated 2015 chart that is very useful and can be used to look up your state’s tax treatment of retirement plan distributions for retirees.