Many employee stock ownership plan (ESOP) participants don’t understand required minimum distribution (RMD) requirements due to their infrequent nature. RMDs come with rules that must be followed, and it’s the participant’s responsibility to be aware of them. Taking a moment to fully analyze the basics of an RMD as listed below will help educate participants on their responsibilities.
What’s an RMD?
The RMD rules, contained in Internal Revenue Code Section 401(a)(9), set the latest date that ESOP benefits must begin to be paid. These RMD rules are in place to help ensure that participants use tax-deferred qualified retirement plans (including ESOPs) to pay retirement benefits and not as an estate planning tool. In general, an RMD is the minimum distribution that a participant must take from their ESOP account when reaching the age of 70 1/2 (if you were born before July 1, 1949) or age 72 (if you were born after June 30, 1949) or age 75 for those who attain age 74 after December 31, 2032 or, if later, the calendar year in which the participant terminates. However, if the participant was age 72 (70 1/2 if reached 70 1/2 before January 1, 2020) and owned a 5% interest in the plan sponsor at the time of the ESOP transaction, the participant must take an RMD regardless of termination. Participants may not elect to defer an RMD, and the RMD may not be rolled over into an IRA or another retirement account.
When Are You Required to Take Your First RMD?
Benefits under an ESOP must begin to be distributed by the “required beginning date” (RBD). This age was originally increased with the SECURE Act of 2019 and further increased by SECURE 2.0. The RBD is April 1 of the calendar year following either 1) the calendar year in which the participant attains age 70 1/2 (if you were born before July 1, 1949) or age 72 (if you were born after June 30, 1949) or age 75 for those who attain age 74 after December 31, 2032 or 2) the calendar year in which the participant severs employment, whichever is later. After the first distribution, the participant will have until December 31 of each year to take the RMD. The participant isn’t limited to that sole amount. A participant can withdraw more without a penalty, but the excess amount can’t be used to lessen the next year’s RMD.
How Is the RMD Calculated?
In general, RMDs are calculated by dividing the ESOP account’s prior year-end balance by the applicable life expectancy factor. The IRS publishes a life expectancy table each year in Publication 590. While the custodian or plan administrator typically calculates the RMD, it’s important the participant understands they are ultimately responsible for calculating the correct RMD amount.
The table used to determine the RMD will be dependent as follows:
- Joint and Last Survivor Table – The sole beneficiary of the account is the spouse, and the spouse is more than 10 years younger than the participant.
- Uniform Lifetime Table – The sole beneficiary isn’t the participant’s spouse, or the participant’s spouse isn’t more than 10 years younger than the participant.
- Single Life Expectancy Table – The beneficiary of the account is the participant.
What Happens if You Fail to Take the RMD?
Participants who fail to withdraw the full amount that’s required or fail to take an RMD will incur stiff penalties. The IRS previously imposed a 50% tax on the distribution amount not taken. The excise tax amount was dropped to 25% with SECURE 2.0, with a possible 10% excise tax if the RMD is timely corrected within two years. The participant will file a Form 5329 along with their Form 1040. The penalty can be waived if the participant can prove the shortage resulted from a reasonable error and that steps are being taken to fix the shortage. A letter of explanation must be attached to Form 5329 to qualify.
How Are RMDs Taxed?
Currently, for federal income tax purposes, an RMD is taxed at the participant’s ordinary income tax rate.
If you have questions on whether you’re required to take an RMD from your ESOP account this year or need assistance computing your RMD, please reach out to a professional at FORVIS or submit the Contact Us form below.