RAs have long been a popular retirement savings vehicle. In addition to making individual contributions, employees who change jobs often roll over employer-provided retirement benefits into self-directed IRAs to gain greater control over how the funds are invested. Because the balances in these accounts can be quite sizable, some IRA owners, especially those with other sources of retirement income, might want to continue generating tax-deferred earnings indefinitely.
Unfortunately, the tax laws require IRA owners to begin taking minimum distributions from traditional IRAs (the rules for Roth IRAs are different) starting with the year they turn age 7012. (Taxpayers can delay the first required distribution until April 1 of the following year.) If they withdraw less than the required amount, the IRS assesses a 50% excise tax on the difference. The required minimum distribution in any year equals the IRA balance on December 31 of the previous year divided by the appropriate life expectancy. Taking distributions toward the end of the year allows IRA owners to accrue additional tax-deferred earnings for that year. However, more important to maximizing the tax-deferred benefits associated with traditional IRAs is using the longest life expectancy possible to compute required distributions. This article provides guidance on how CPAs can help some IRA owners prolong the distribution period by naming a designated beneficiary, establishing multiple IRAs or recalculating the owner’s life expectancy.
USING LIFE EXPECTANCY TABLES
To compute required IRA distributions for an account with no designated beneficiary, an owner uses the single life expectancy tables to determine his or her life expectancy. Having a designated beneficiary allows the owner to use the joint life expectancy tables to compute required distributions based on the joint life expectancy of the owner and the designated beneficiary. This joint life expectancy is always longer than the owner’s single life expectancy. The tables in the exhibit on page belw show that the single life expectancy of a 70-year-old IRA owner is 16 years, whereas the joint life expectancy of the same person and another 70-year-old is 20.6 years—an increase of 4.6 years. If the designated beneficiary is younger than the owner, the joint life expectancy is even longer. For example, if the designated beneficiary is 60 instead of 70, the joint life expectancy is 26.2 years. Thus, IRA owners can substantially lengthen the life expectancy used in computing required distributions (thereby maximizing the amount remaining in the IRA) by naming a designated beneficiary.
RULES FOR NAMING A BENEFICIARY
Although any individual or entity can be named as an IRA beneficiary, generally, only individuals qualify as so-called designated beneficiaries. If a charity or the owner’s estate, for example, is a beneficiary or co-beneficiary, the IRA is treated as having no designated beneficiary and the owner must compute required distributions using his or her single life expectancy. When the IRA owner wants both individual and other beneficiaries, establishing separate IRAs for each beneficiary can lengthen the life expectancy used to compute required distributions.
Example. Diane names her brother and a charity as the beneficiaries of her IRA. Because the charity cannot be a designated beneficiary, required distributions must be made over Diane’s single life expectancy. If Diane established two IRAs with her brother as the beneficiary of one and the charity as the beneficiary of the other, she could receive distributions from the first account over her and her brother’s joint life expectancy. Required distributions from the second IRA would be made over her single life expectancy.
The designated beneficiary is determined as of the owner’s required beginning date (RBD) for taking distributions—April 1 of the year after the year in which the owner turns age 70 12 . Thus, an IRA owner who turns 70 on February 15, 2000, turns 70 12 on August 15, 2000, and accordingly, would have an April 1, 2001 RBD. However, an owner who turns 70 on August 5, 2000, does not turn 70 12 until February 5, 2001, and therefore would have until the April 1, 2002 RBD to name a designated beneficiary. If there is more than one designated beneficiary on the RBD, the one with the shortest life expectancy is used to determine joint life expectancy. If an owner has multiple beneficiaries in mind, establishing a separate IRA for each one ensures the smallest possible distribution each year.
Example. Ginny’s brother and sister are the beneficiaries of her IRA. Ginny turns 70 12 on November 14, 2000; her brother and sister that year are 62 and 66, respectively. The 2000 required distribution is based on the joint life expectancy for 70 and 66, or 22.5 years. Had Ginny established separate IRAs before her April 1, 2001 RBD, she would still use the 22.5-year joint life expectancy for the IRA of which her sister is the beneficiary. However, she would use the longer joint life expectancy of 24.9 years (ages 70 and 62) for the IRA of which her brother is the beneficiary.
When the designated beneficiary is not the owner’s spouse, the age of the designated beneficiary used in determining the joint life expectancy can be no more than 10 years younger than the IRA owner, regardless of the designated beneficiary’s actual age.
Example. Susan turns 70 12 on April 16, 2000. Her 39-year-old daughter is the beneficiary of her IRA. In computing her 2000 required distribution, Susan uses the joint life expectancy of 25.3 years (ages 71—Susan’s age in 2000—and 61, the maximum 10 years younger than her age).
If after the RBD the owner adds a beneficiary with a shorter life expectancy, minimum required distributions starting with the following distribution year are computed by replacing the existing designated beneficiary with a new one, thereby shortening the life expectancy used to compute required distributions. However, adding a beneficiary with a longer life expectancy has no effect on the required distributions.
DISTRIBUTIONS FROM MULTIPLE IRAs
Owners with several IRAs compute the minimum distributions using the appropriate life expectancy for each account. The aggregate of the required distributions from all traditional IRAs must be made during the year, but distributions can be made from any of the owner’s traditional IRAs. The decision regarding which account to take distributions from can affect the future earnings and distributions from the various accounts.
Example. Curt turns 70 12 on March 8, 2001. On December 31, 2000, the balances in his traditional IRAs were $40,000 and $10,000. As of Curt’s RBD, his wife and a charity are the respective beneficiaries of these accounts. His wife turns 58 in 2001. Therefore, Curt uses the joint life expectancy of 27.5 years (ages 71 and 58) to compute the 2001 required distribution from the first IRA; a life expectancy of 15.3 years (age 71 from the single life table) applies to the second IRA. The aggregate required distribution is $2,109 ($1,455 for the first account; $654 for the second). Curt can withdraw the entire $2,109 from the second IRA, thereby maximizing both the balance and future earnings in the IRA with the longer distribution period.
TO RECALCULATE OR NOT?
Another way to extend the life expectancy used in computing required distributions is to recalculate the owner’s life expectancy each distribution year. Under this method, the life expectancy is based on the owner’s actual age at the end of each distribution year. Without recalculation, the owner’s life expectancy is one year less than the life expectancy used in the previous year.
Example. Joann turned 70 12 on December 2, 1999. Her IRA has no designated beneficiary. From table 1 in the exhibit, the single life expectancy for age 70 is 16 years. In 2000, Joann will use the remaining life expectancy of 15 years if she does not recalculate her life expectancy. If she does elect to recalculate, she uses the slightly longer 15.3 years—the single life expectancy for age 71.
As a general rule, CPAs should not recommend recalculation. Although the method marginally increases the life expectancy used during the owner’s lifetime, distributions accelerate after the owner dies because the owner’s life expectancy is zero beginning with the year after his or her death. When the spouse is the sole beneficiary, the owner also must decide whether to recalculate the spouse’s life expectancy. (Recalculation is not an option for non-spouse beneficiaries.) The sidebar, “Recalculating Life Expectancies,” above, describes the recalculation method more fully, including a discussion of when it might be advantageous.
Whether an IRA owner uses the recalculation method also depends on the IRA plan documents. Some plans don’t allow it unless the owner elects to recalculate the life expectancy of either the owner or the spouse. The owner must make such an election by his or her RBD; once made, it cannot be revoked. Some plans are silent on recalculation, in which case the owner’s (and spouse’s, if applicable) life expectancy must be recalculated each year. Consequently, when establishing an IRA the owners should be aware of the plan’s recalculation policy and make sure they make any required distribution elections before the RBD.
Although extending the distribution period during the IRA owner’s lifetime is advisable, it is equally important that CPAs recommend clients take the necessary steps to ensure that after the owner dies, the beneficiaries are entitled to the longest distribution period possible. The distribution rules for beneficiaries depend on whether or not the owner died before the RBD.
Before RBD. When the IRA owner dies before reaching the RBD, the five-year rule requires that all amounts in the IRA be distributed to the beneficiaries no later than December 31 of the calendar year that includes the fifth anniversary of the owner’s death. The exception to the five-year rule allows designated beneficiaries to receive distributions over the beneficiary’s life expectancy, as long as they begin by December 31 of the year after the owner dies. When the beneficiary is not an individual, there is no designated beneficiary and distributions must be made under the five-year rule. Thus, as long as the IRA owner establishes separate accounts for each beneficiary before his or her death, the exception to the five-year rule will be available for accounts that have a designated beneficiary.
The IRA agreement can specify whether distributions will be made using the five-year rule or the exception. The agreement also can allow the owner or beneficiary to decide which method to use. When the plan is silent, in the case of a non-spouse beneficiary, distributions must be made under the five-year rule. When the owner’s spouse is the designated beneficiary, distributions must be made in accordance with the exception to the five-year rule. Other special rules that apply when the owner’s spouse is the sole beneficiary are discussed in the sidebar, “Special Rules for a Spouse,” below.
Example. Kathy dies on June 22, 2001, before reaching her RBD. Kathy’s son, Bruce, is her designated beneficiary. If the agreement allows Bruce to decide which distribution method to use, he has the following options:
On or after RBD. When the IRA owner dies on or after the RBD, the remaining balance must be distributed to the beneficiaries at least as fast as the method the owner was using to take distributions. (This rule does not apply to surviving spouses who elect to treat the decedent’s IRA as their own; see the sidebar on page 37). Also, the rule requiring that the age of a non-spouse designated beneficiary when determining the joint life expectancy be no more than 10 years younger than the owner’s age applies only during the IRA owner’s lifetime. When the owner’s life expectancy is not recalculated, the joint life expectancy used in computing required distributions starting the year after the owner dies is based on the actual ages of the IRA owner and the designated beneficiary in the year distributions first begin, reduced by 1 for each distribution year that has lapsed.
Example. Todd turned 70 12 on May 10, 1994. His son, Carlos, is the designated beneficiary of his IRA. Carlos turned 40 during 1994 and Todd does not recalculate his life expectancy. Todd uses the joint life expectancy of ages 71 and 61 (no more than 10 years younger than Todd’s age) to compute his required distribution for the first distribution year.
Todd dies in 2000. Had Carlos’ actual age been used in 1994, the required distribution for that year would have been computed using a joint life expectancy of 42.8 (ages 71 and 40); and 7 years later (in 2001, the year after Todd dies), 35.8 years of the joint life expectancy would remain. Therefore, at least 135.8 of the amount in the IRA as of December 31, 2000, must be distributed to Carlos by December 31, 2001, and at least 134.8 of the December 31, 2001 balance must be distributed during 2002.
With proper planning before the owner’s RBD (or before the owner dies), CPAs can help clients extend distributions from a traditional IRA significantly, thereby allowing additional tax-deferred earnings to accrue. There are three situations where establishing multiple IRAs may be advantageous: when the IRA owner wants both individual and entity beneficiaries, when one of the beneficiaries is the owner’s spouse or when the beneficiaries are different ages. Establishing a separate IRA for each beneficiary allows for computation of required distributions using the joint life expectancy table for IRAs that have a designated beneficiary and can provide the heirs with more options after the owner dies. It is imperative when establishing an IRA that the owner be aware of the plan provisions regarding use of the recalculation method and the distribution options available to beneficiaries who eventually inherit the owner’s IRA.