Required Minimum Distributions and the Roth Recharacterization Issue

By Beverly DeVeny
Follow Me on Twitter: @BevIRAEdSlott

When you have an IRA required minimum distribution (RMD) for the year, you generally use the prior year-end IRA account balance to calculate the RMD. There are a couple of exceptions to this rule and Roth recharacterizations are one of them.

Example: Pamela, who is 72, converted $100,000 of her $300,000 IRA account to a Roth IRA last year. This year, the value of the assets used for her Roth conversion has declined to $75,000. If she does nothing,  she will owe income tax on the value that is no longer there. So Melissa decides to recharacterize her Roth IRA conversion in September. The net amount of her converted assets ($75,000) is directly transferred back to her IRA account. The recharacterization treats the $100,000 conversion as if it had never left the IRA. 

What happens to Pamela’s RMD for the year? Normally it would be calculated on her year-end account value of $200,000. But, if the recharacterization treats the $100,000 as if it never left the IRA, then an adjustment must be made to her year-end account value. The tax code says that the amount that is returned to the IRA must be added back in to the year-end account value. For Pamela, that means that she must add $75,000 to her $200,000 year-end account balance for purposes of calculating her RMD for this year.

What happens if no one explains this adjustment to Pamela and she takes her RMD based on the letter she got from her IRA custodian in January? Remember that the Roth recharacterization had not yet taken place in January. If Pamela only takes out the amount that was calculated and communicated to her in January, she will not have taken her full RMD for the year.

There is good news and bad news if this happens. The bad news is that any portion of an RMD that is not timely taken is subject to a penalty of 50% of the amount not taken. That is 50%. It is not a typo. The penalty is reported and calculated on IRS Form 5329, which Pamela should file with her tax return.

But wait, there is even worse news. Form 5329 is considered a tax return because it has a signature line. If Pamela does not report the penalty on Form 5329, the statute of limitations does not start to run. She will continue to owe the penalty, year after year, plus interest, plus failure to file penalties, and perhaps accuracy related penalties, plus interest. Congress and IRS are not fooling around here. They want you to take your full RMD each and every year.

Now for the good news. IRS can waive the penalty for good cause. Let’s say that Pamela tells her tax preparer about all of her IRA and Roth IRA transactions. She is lucky and has a sharp tax preparer that picks up on the fact that she did not take her full RMD. He advises her to immediately take a distribution of the amount not taken last year. He also prepares Form 5329 to file with her tax return showing zero as the amount due. He includes a note explaining why Pamela did not take her full RMD and asks IRS to forgive the penalty. In most cases, IRS will forgive the penalty.