By Andy Ives, CFP®, AIF®
IRA Analyst

A required minimum distribution (RMD) from a 401(k) (or other employer plan) must be taken prior to rolling remaining plan dollars to an IRA. An RMD cannot be rolled over, so it must be withdrawn before any rollover is completed. While this concept appears somewhat basic, it is easy to get sideways with the rules. Additionally, unexpected changes in employment, combined with the still-working exception, can retroactively create RMD problems.

Many retired people of RMD age (70 ½ prior to the SECURE Act, age 72 since) look to consolidate retirement accounts. Since they are no longer working for a company, the idea of rolling 401(k) plan assets into an IRA makes sense. Easy enough. However, before a rollover can be completed, the annual plan RMD must be taken first. You cannot roll the entire balance into the IRA and then take the plan RMD from the IRA later in the year. Not allowed.

If the plan RMD is erroneously rolled into the IRA, then we have an excess contribution in the IRA for the RMD amount. This excess (plus any earnings attributable to the excess) must be removed from the IRA, and that withdrawal must be coded as an excess contribution withdrawal. If the excess is not removed by the following October 15, there is a 6% penalty for every year it remains.

Individuals of RMD age who are still working can oftentimes delay the start of plan RMDs. Most plans offer an optional plan feature called the “still-working exception.” If a plan participant does not own more than 5% of the company and the plan allows, she can delay her required beginning date (RBD) to April 1 of the year following the year of separation from service. (Note that this exception does NOT apply to IRAs, SEPs or SIMPLEs. It also does not apply to employer plans if a person is not currently working for that company.)

Nevertheless, despite the best-laid RMD plans, unexpected changes in employment can transform a proper rollover into a problematic excess contribution. Here’s how:

Example: Janice, age 74, has been working for a small business for 20 years. She has diligently made salary deferrals into the company’s 401(k) plan and has accumulated $250,000. Since the plan has the still-working exception, Janice does not need to take an RMD from the plan until she separates from service. Janice intends to retire next year. In preparation for retirement (and in order to access a particular investment unavailable in her work plan), Janice takes an in-service distribution of $100,000 which she rolls into her IRA. She wisely leaves $150,000 in the 401(k) so that it will not factor into her IRA RMD next year. After December 31, she plans to roll the remaining $150,000 to her IRA.

Soon after Janice’s $100,000 rollover, torrential rains and flooding destroy the company. The doors are shuttered, and the entire staff is let go. Since Janice has now officially “separated from service” – even though the separation was not her decision – the still-working exception no longer applies. Janice now has an RMD on her plan assets for this year. The “first-dollars out rule” dictates that the first dollars taken from a plan or IRA include the RMD. As such, Janice’s $100,000 rollover is retroactively deemed to have included her 401(k) RMD. Despite her best-laid plans, she now has an excess contribution in her IRA that must be addressed.