RMD for 5% owner accounting

Hi Folks,

Wondering if we can simplify the management of a small plan, owner is subject to RMD under § 1.401(a)(9)-2(b)(3) 5% rule and currently contributing to the plan. Is it allowed to reduce the transfers of cash in such a situation, for example:

1. RMD is $10,000.
2. Contribution is $15,000.
3. Contribute $5,000 and do not remove assets from plan.

It seems economically the same to the plan, and the owner still receives their 1099-R for $10,000 so they are paying appropriate taxes, just not sure if there is any rule that I might be overlooking here?

Thanks for any insight!

No. What would justify the 1099? There was no distribution.

My thinking was that if the plan has a starting value and a contribution amount, then if the end value is equal there was a distribution.

The resulting balances and taxable events would be the same for either method:

For a plan that has both contributions and distributions in the same year, the economic effect is the same in both cases.
Mathematically, the plan paid out the correct amount, the recipient paid the correct tax. The plan also received the correct amount when we consider a netting of these.

I guess the 'why' is why does physical movement have to occur? I was under the impression that with plans like a mega-backdoor 401(k)™ it could be administered within a single account, with the record keepers tracking what was a voluntarily contribution and what had been transferred into Roth status.  That would (I thought) create a 1099-R even if the funds don't physically move into a Roth IRA outside of the plan (they can remain inside the account). If that is accurate, then that's what I was thinking.

Also, there seems to be zero difference here, which makes it seem acceptable:

1. Withdraw cash day 1 satisfy RMD.
2. Put cash back in day 1 satisfy Contribution.

I guess I don't grasp what within that would warrant lack of compliance with satisfying RMD and Contributions? The balances don't change, the plan distributes as it should, the owner recognizes income as they should, so what part of this causes the problem?
 

The math works out but you can't simply net implied transactions - you don't have deposit to match contribution deduction and don't have a distribution to demonstrate RMD and justify a 1099R. I would not want to try to convince an IRS auditor that this is all OK because we get to the same place despite skipping the intermediate steps.

And PS contributions are discretionary, so what you are proposing is also equivalent to being able to avoid actual RMD and just say "I made a contribution for the same amount" and then book corresponding deduction and 1099R. These are separate and distinct transactions, not interrelated recordkeeping actions like Roth conversions. Would you directly deposit $30,000 into a Roth IRA and call it a rollover of voluntary after tax and generate a 1099 to substantiate without actually contributing to the plan, then withdrawing/rolling? I wouldn't.

A. Logic has no place in retirement plan discussions

B. Your logic is flawed anyway as noted by CuseFan

1 hour ago, C. B. Zeller said:

Your chart also seems to be saying that the $10,000 will simply remain in the business account. The RMD doesn't get paid to the business, it gets paid to the participant. The business would have to pay it out to the participant in that case, and there might be questions why a payment directly from the business to an employee isn't being treated as wages.

Again, that's somewhat arbitrary. The RMD gets paid to the person, the person is the business owner, the person deposits the RMD into the business means that:

1. The person gets a 1099R for taxable (personal) income.
2. The person puts the money into the business (which is a capital transaction, increasing basis in the business).
3. There are no questions about why a payment from the business isn't wages because we have basis inside the business entity. The owner is able to add and withdraw to that at will.
4. So again, it is skipping steps, but no different from if the business were to buy a flight for the business owner that happened to be a non business expense, it wouldn't be wages or travel, it is a capital transaction.

1 hour ago, CuseFan said:

And PS contributions are discretionary, so what you are proposing is also equivalent to being able to avoid actual RMD and just say "I made a contribution for the same amount" and then book corresponding deduction and 1099R. These are separate and distinct transactions, not interrelated recordkeeping actions like Roth conversions.

I think that is an incorrect conclusion. We are only talking about mechanics of payment:

The RMD is being taken, it is being taxed to the individual whether they do it 'the proper way' or 'the proposed way' there is absolutely no advantage gained other than reduction in capital transfers and efficiency gained.

59 minutes ago, Bird said:

A. Logic has no place in retirement plan discussions

True that.
 

59 minutes ago, Bird said:

B. Your logic is flawed anyway as noted by CuseFan

I disagree with that.

Appreciate the insights though, thanks for your time everyone who weighed in, I'll give it some more thought.
 

1) No one here doesn't understand what you are saying. 

2) We are saying we understand and we think it is a bad idea for the reasons listed.

3) I will add you are being too clever.  Whatever savings you think is being gotten it is too little for the risk.  Don't net like this.  If an audit comes you have to spend a ton of tome explaining it and if they don't get it for some reason the client is in trouble.   I mean how much can the saving be?  You have most likely spent more time arguing for the idea here than it would take to do the two transactions. 

I am all for labor savings just not dumb labor savings and this one is dumb.   

Why not try out the idea first with a small plan of your own? A test run where no one else is at risk? When audited, explain that no RMD was needed because you intended to contribute, etc., etc. Then post the results here once the audit is closed to let us know how much billable time was spent, if the arguments were successful, how much excise tax was paid and any interest and/or penalties. Maybe it would be worth it?

Just went through an IRS audit for a client. Had to point out (more than once) that the amount of the contributions for the year matched the Form 5500, matched the trust deposit, and matched the company's deduction, etc. Two years down the road when this client gets audited, you will not be able to just give copies of the contribution check, contribution deposit, and shoe corresponding amounts on the Form 5500 and business tax return. As others have pointed out, it's not worth the time to explain this later. If everything matches up, no explanation is needed. (And I might add that the agent we had seemed to not be familiar with some basic retirement plan knowledge despite working as an IRS auditor for 15 years. I would not have wanted to explain this situation.)

Matt - please take heed of the advice in previous comments - they have you and your client's best interests at heart. Among other things, a requirement for plan qualification is that a plan MUST BE OPERATED ACCORDING TO ITS TERMS. If you don't, it is an operational error, and the plan is subject to penalties and potential disqualification. I'll bet the farm that you can't find a valid document out there that doesn't specify that a distribution must be made from the PLAN. There's no IRS approval of a document that says, "Oh, it is ok for the EMPLOYER to just write a check directly to the participant and count it as a distribution FROM the PLAN." 

If you were to attempt this in your own practice, make sure your E&O is ironclad. Echoing the prior comments, it just ain't worth it. I don't disagree with you that it would be convenient, but that's not the issue when it comes to compliance.

Right, you’d have to modify the plan’s written terms to do it this way. After doing that, you should submit the plan document to the IRS for a determination letter.

No virtual contribution is worth the paper it is written on. Must have proper paper trail

On 3/23/2023 at 2:47 PM, Lou S. said:

 ...even if from a tax perspective it comes out just the same.

NOT the same.  There is different FICA taxation.

26 minutes ago, david rigby said:

NOT the same.  There is different FICA taxation.

This may be true. It's certainly true if it's done as a corporate 401(k) contribution. But then you'd need the W-2 to reflect the phantom 401(k) contribution and be straying even further on to shaky ground.

We know the plan must follow its terms.

We know that a plan fiduciary's best practice is to document, document, document what, when and why anything that is done in the management and administration of the plan.

We know that documentation of transactions and participants' elections that are supported by contemporaneous financial statements and signed documents and administrative forms have the most credibility with the IRS and DOL.

Let's hope that the plan fiduciaries - including the trustees - who receive advice that the plan can be operated based on unsupported bookkeeping entries know better.  They are the ones who will be held accountable.

Hard to think of a worse idea.

And the audit risk is two-fold: if the plan gets audited OR the individual.