Can it ever be the case that an individual retirement account's required minimum distribution, or RMD, for a year equals the entire IRA balance? Yes, but that only happens if there is no designated beneficiary.
A designated beneficiary means an individual beneficiary named on the IRA beneficiary form. Often there is no designated beneficiary, either because no beneficiary was named on the beneficiary form or the named beneficiary is not an individual but instead is an estate, charity or non-qualifying trust.
Even if the IRA eventually goes to an individual beneficiary, if it gets to that beneficiary through the estate for example, then there is no designated beneficiary.
The 100% RMD occurs when there is no designated beneficiary and the IRA owner died before his or her required beginning date (April 1 of the year following the year the IRA owner reaches age 70½).
In that case, the entire inherited IRA must be paid out under the so-called "five-year rule," which says an IRA must be withdrawn in full by the end of the fifth year after the year of the owner's death. Unlike a stretch IRA, where withdrawals are taken ratably over many years, under the five-year rule no distributions are required during the first through fourth years after the owner's death. But whatever is left in the inherited IRA in the fifth year must all be withdrawn in that year. In this case, the fifth year RMD is 100% of the account balance, and that RMD will be taxable all in one year (unless this is an inherited Roth IRA).
(More: 5 costly inherited IRA mistakes)
Josie never named a beneficiary on her IRA, so when she died in 2013 at age 65, her estate became her beneficiary by default.
Because the estate was the beneficiary and Josie died before her required beginning date, the five-year rule applied. This means that Josie's entire IRA had to be emptied by Dec. 31, 2018.
Josie's will named her two sons, Len and Ben, as co-executors of her estate. Len and Ben never got along and they fight about everything. As a result, in 2019, Josie's IRA is still sitting there. The estate will owe the 50% penalty for 2018 on the total balance of Josie's IRA for 2018 because that was the year the RMD was 100% of the IRA. If Len and Ben do not take a total distribution in 2019, the 50% penalty will apply for that year too and for every year the RMD — the total amount in the IRA — remains undistributed.
If the beneficiary neglects the 100% RMD for even a few years, the 50% penalty can actually exceed the amount of the total IRA balance, leaving the beneficiary with a growing tax debt instead of an expected inheritance, especially when you add in the mounting penalties and interest. Advisers need to react quickly to recognize the problem and to have these RMD penalties waived.
To have the penalty waived, the beneficiary must take the missed RMD and then file Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts) to request a penalty waiver. The form must be filed for each year there was a missed RMD. There is no statute of limitations if this form is not filed, so the 50% penalty will never go away unless the waiver is requested.
Roth IRA Trap
This 100% RMD situation hits inherited Roth IRAs harder. When there is no designated beneficiary on a Roth IRA, the inherited Roth funds will always be subject to the five-year rule, no matter when the Roth IRA owner died.
Roth IRA owners are not subject to RMDs during their lifetime so there is no required beginning date for a Roth owner. This means that whenever a Roth IRA owner dies without a designated beneficiary, that inherited Roth will be subject to the five-year rule. That can put a real damper on the tax-free growth for the beneficiary.
The 100% RMD will be tough for an adviser to explain to a beneficiary when this outcome could be avoided just by checking IRA beneficiary forms to make sure intended beneficiaries are named.