5 Things You MUST Know (But Probably Don’t) About the “Still Working Exception”

By Jeffrey Levine, Director of Retirement Education
Follow Me on Twitter: @IRAGuru4EdSlott

In general, when you reach age 70 ½, you must begin to take required minimum distributions (RMDs) from your retirement accounts. There are, however, a number of exceptions to this rule. One such exception is commonly known as the “still working exception.” Under this exception, you may not have to take a distribution from your 401(k) or similar plan if:

• You’re still working for the employer sponsoring the plan
• You’re not a “5-percent owner” of the company

That seems pretty straightforward, but like most things in the tax code, this exception is needlessly – and seemingly endlessly – complicated. Don’t believe me? Here’s a sample of just what I mean.
 

1. You Can’t Own MORE Than 5% of the Company
   Many people are under the false impression that the 5-percent rule means that you can’t own 5% of the company you’re still working for and still meet the requirements of the still working exception. That’s not surprising, considering that the tax code explicitly states that the rule won’t apply “in the case of an employee who is a 5-percent owner.” However, the code goes on to say that a “5-percent owner” shall be defined in section 416, and in that section, a “5-percent owner” is defined as someone who owns more than five percent of a company. This is precisely the type of wild goose chase that drives people crazy (and leads to mistakes and misconceptions).
    
2. It’s All In the Family
   Another little known aspect of the still working exception is that the 5-percent test looks not just at your personal ownership percentage in your employer, but also that of a number of other related persons/entities. For instance, when determining if you own more than 5% of the company, you must add together your ownership percentage with that of your spouse, children, grandchildren, as well as ownership interests you may have via an estate, a trust, a partnership or a corporation. So, for instance, if you own 3% of a company and your child owns 3% of a company, you are both considered to be 5-percent owners and neither of you would be able to delay RMDs using the still working exception.
    
3. The 5-Percent Test Is Assessed When You Turn 70 ½
   The 5-percent ownership test is not an ongoing test. Your ownership in your employer is locked in, so to speak, in the year you turn 70 ½ (technically it’s determined in the “plan year ending in the calendar year in which the [you reach] age 70 ½”). Therefore, if you’re a 5-percent owner of a company when you turn age 70 ½ and don’t qualify for the still working exception, you will always be a 5-percent owner, regardless of future ownership divestiture. For instance, suppose you own 10% of the stock of your employer when you reach age 70 ½. As such, you would not be eligible to utilize the still working exception. What if, however, when you turned 73, you sold all of that stock to an unrelated person and had absolutely no ownership interest in your employer? For the purpose of the 5-percent rule, it wouldn’t matter. You’d still be considered a 5-percent owner and would have to take RMDs from your plan balance each and every year.
    
4. The Rules Work Slightly Different for Corporations vs. Other Entities
   When most people think of owning a company, they think about owning the stock of that company. The reality of the situation, though, is that there are many types of ownership and the rules for the 5-percent test vary depending upon the type of ownership. If your employer is a corporation, you are considered a 5-percent owner if you own more than 5% of the outstanding stock or control more than 5% of the voting interest in the corporation. For other entities, such as partnerships, the test is assessed against both capital and profit interests. If you have more than a 5-percent ownership interest in either, you can’t utilize the still working exception. 
    
5. It Doesn’t Apply to IRA-Based Plans
   If you own an IRA, then like all IRA owners, you must begin taking RMDs when you turn age 70 ½ (technically you can wait and timely take your first RMD up through April 1 of the year after you turn age 70 ½, but it’s still for the year you turn age 70 ½). The rule applies regardless of what kind of IRA you own (other than a Roth IRA – which has no RMDs during your lifetime), including SEP IRAs and SIMPLE IRAs. Even though these are retirement plans which need to be established and maintained by an employer, their RMD rules follow the IRA rules. Thus, even if you’re still working for a company sponsoring a SEP IRA or SIMPLE IRA plan, and even if you’re still receiving employer contributions each year because you’re still working, once you turn age 70 ½, you will have to begin taking annual distributions.