How To Avoid Paying Extra Taxes and Penalties in a Self-Directed IRA Part 3 – Excess Accumulations

Posted on: November 22, 2021   |   Category: In The News
Excess Accumulations, Tax

Self-Directed IRA account holders have a greater obligation to be aware of the IRS rules. Since they take a more active role in their retirement investing, they don’t always have the safety net which comes with an institutionalized platform. Usually this required awareness pertains to the improper use of Self-Directed IRA funds. The account holder could potentially take the funds out too early or invest them in a way deemed prohibited. But what about the opposite case? Can an account holder get into trouble for improperly not using retirement funds? Yes! In IRS jargon this situation is known as excess accumulations or insufficient distributions. 

Even though the government is in favor of Americans saving for retirement, they don’t want you to save for too long. If you have retirement funds in a Self-Directed IRA (or any other retirement account,) at some point you have to start taking distributions. The reason for this is that the government would like to get its tax dollars. Once you start taking distributions, the tax bill comes due. Another reason for requiring distributions is to keep retirement accounts focused on retirement. If the funds could stay there forever, then individuals would have access to a tax-saving account to manage their wealth and would use these accounts accordingly. These retirement accounts would cease to be accounts incentivized for retirement saving. 

When do excess accumulations become a problem? 

You can start withdrawing funds from your Self-Directed IRA at 59.5 years of age. However, when you turn 72, you must take a distribution. This annual requirement is known as a RMD – Required Minimum Distribution. The amount of the distribution varies and is dependent upon the age of the account holder and the amount of money in the account. You can find IRS worksheets to determine your RMD here. (Although usually it’s just easier to ask your accountant.) 

Once you have figured out your Self-Directed IRA RMD, then you need to withdraw it from the account. The deadline for withdrawing the RMD is December 31. (An exception to this rule is the first RMD that needs to be taken after the account holder turns 72. The deadline for that one is April 1.)  

What are the consequences of excess accumulations? 

The penalty for not taking out a RMD is harsh. It’s 50% of the required amount not distributed. For example, if the RMD for the year is $5,000, and the account holder withdraws just $1,000, then that means $4,000 is considered an excess accumulation. In addition to the regular taxes due on that $4,000, the account holder will also have to pay a 50% penalty of $2,000. But it doesn’t stop there. The IRS also makes you fill out additional paperwork. (For some this is even scarier than the penalty.) When paying the penalty on the excess accumulation, the account holder must complete IRS Form 5329

What if the excess accumulation happened by accident? 

Sometimes people make mistakes. It could be that you miscalculated when determining your Self-Directed IRA’s RMD, or maybe even your accountant did. (Although they would really not like to admit it.) In such a case, all is not lost. The IRS says that you still need to submit Form 5329, but you should also submit a statement explaining what happened. The IRS will review it and if they deem it to be legitimate, will likely forgive the excess accumulation penalty. 

The excess accumulation challenge of real estate 

Real estate is one of the most popular Self Directed IRA investments and for good reason. It is an intuitive investment, one that can be easily understood by most investors, and it often boast conservative steady property streams. The property itself slowly accrues in value while monthly cash flow is provided by rental income. However, if real estate has a downside, it can be found in the administrative challenge of Required Minimum Distributions. This downside should in no way discourage Self Directed IRA investors from this asset; rather it just requires a little bit more forethought to stay compliant. 

Here is the problem. Real estate is not easily cashed out in pieces. That means that when it comes time to take a RMD, you can’t just sell a percentage of it like you can do with stocks. So what’s a Self-Directed IRA investor to do? You don’t want to get hit with a 50% penalty for excess accumulation, but you may also not want to sell the entire property. Don’t worry. There are a number of solutions available and you can choose the one that works best for you. 

  1. You can fulfill your RMD by taking an in-kind distribution. What this means is that you transfer a stake in the ownership of the property to yourself, while the remainder continues to be owned by the Self-Directed IRA account. The percentage that you transfer to your personal ownership counts as your RMD. This process requires filling out a number of forms, as well as receiving a qualified appraisal. 
  1. You can fulfill your RMD requirements by taking out the required amount from other retirement assets. For instance, if you have some of your IRA invested in stocks or if you have cash in a retirement account, you can use those options for your Required Minimum Distribution. The RMD can be taken from any of your retirement assets and it does not need to be distributed evenly. 
  1. The third option may be the one you didn’t want to consider. Namely, just sell the property in its entirety. Once the property is sold, the cash proceeds will be deposited in your Self-Directed IRA account. You can take the RMD from that cash and thereby avoid the excess accumulation penalty. With the remaining proceeds you can decide if you want to reinvest them, leave them in savings, or withdraw the entire amount. There may be a required minimum distribution, but there is no maximum limit. 

Additional facts about excess accumulations in a Self-Directed IRA 

  • If your Self-Directed IRA is invested in an annuity or other contractual product from an insurance company that is going through delinquency proceedings, you may not have to take an RMD that year. Ask your financial advisor if your situation qualifies. 
  • Excess accumulations do not apply to Self-Directed Roth IRAs as they have no mandated RMDs. 
  • Occasionally the government waives the RMD requirement like it did for 2020 due to the Covid pandemic.