New Rules for IRA Distributions

The role of the required beginning date.

Beneficiary designations.

Treatment of lifetime distributions.

Treatment of postmortem distributions.

IRA owners are allowed, but not required, to follow the new regulations for 2001. Qualified plan participants may not, however, take advantage of the new rules until their employers first amend the plans. The IRS has announced its intention to make the proposed regulations final effective January 1, 2002.

Under the 1987 distribution rules, two elections taxpayers made on the required beginning date—when mandatory minimum distributions must begin—were critical for those who wanted to optimize the tax-deferred growth of plan assets for both themselves and their designated beneficiaries. The first election concerned the designation of beneficiaries; the second fixed forever the method used to calculate required minimum distributions. A taxpayer who even inadvertently made an error in either election paid a high price for his or her folly by accelerating distributions and incurring higher income taxes. The new regulations strip the required beginning date of its importance. Hereafter, that date is simply the day on which taxpayers must begin taking minimum distributions. It has no other function or significance.

BENEFICIARY DESIGNATIONS

The proposed regulations vastly liberalize the requirements for designating a beneficiary and make both lifetime and postmortem planning easier for CPAs and their clients. They repeal the prior rule that taxpayers designate a beneficiary by the required beginning date. Instead, the final beneficiary designation may be postponed until December 31 of the calendar year immediately following the participant’s or IRA owner’s death.

Yet this new provision may confuse some taxpayers and their CPAs and lull them into inaction. If a plan participant dies without designating a beneficiary or names his or her estate or a nonqualified trust, the retirement plan is treated as having no designated beneficiary. This means the distribution period cannot exceed the participant’s life expectancy. The estate may not add beneficiaries after the participant’s death. Under the proposed regulations the executor or the estate must make the final beneficiary determination from among the beneficiaries the participant has already designated by December 31 of the calendar year following the participant’s death.

If the participant dies before the required beginning date, the new regulations permit the executor or the estate to establish a separate account for each designated beneficiary. But the proposed regulations do not clearly state whether the same favorable treatment is available for a participant who dies after the required beginning date. Similarly, the new regulations do not provide clear guidance on whether the executor or estate can create separate shares when a participant who dies after the required beginning date has named a charitable organization or a nonqualified trust as one of several beneficiaries.

The safest way to avoid this uncertainty is for CPAs to recommend that the client establish a separate account for each beneficiary during the client’s lifetime. If the participant does not wish to create separate accounts for charities and nonqualified trusts, the participant may assign a fractional interest in the account balance to them. Upon the participant’s death, the bequests will be cashed out.

Example 1. Abigail Adams died at age 65 after designating her son Abel and granddaughter Ann as the beneficiaries of her IRA. She also directed that $50,000 be paid from her IRA to the American Cancer Society. The proposed regulations clarify that a designated beneficiary may waive his or her rights. Therefore, Abigail’s son may elect to waive his interest in the IRA, cash out his interest or establish a separate account. The charity will receive its bequest, leaving granddaughter Ann as the sole beneficiary of the remaining account balance, which she will receive over her life expectancy.

Another important and far-reaching change in the new regulations concerns mandatory lifetime distributions. Gone are the days when a participant and his or her CPA agonized over making the right irrevocable election from among many distribution methods to achieve maximum tax deferral. Instead, most taxpayers will now use a single, straightforward table to calculate mandatory minimum distribution amounts (see exhibit at right).

The new table for lifetime minimum distributions is based on the automatic assumption that a participant has already designated a beneficiary who is more than 10 years younger. Therefore, neither the existence nor the identity of the beneficiary any longer has an impact on lifetime minimum distributions. A limited exception is carved out when the participant’s sole beneficiary is a surviving spouse who is more than 10 years younger.

The required minimum distribution computation now boils down to a simple, two-step process:

Determine the participant’s retirement account balance as of December 31 of the prior year.

Divide that amount by the applicable life expectancy factor from the uniform table in the exhibit at right. The factor will vary depending on the participant’s attained age on his or her birthday in the distribution year.

Example 2. Adam Smith was 84 years old on April 10, 2001. He had an IRA balance of $1.2 million as of December 31, 2000. His minimum required distribution for 2001 is $87,758.62 ($1,200,000 divided by the 14.5 life expectancy factor).

Apart from its simplicity, the new method confers a number of benefits on both plan participants and their beneficiaries:

All participants and beneficiaries automatically receive the benefits of the old recalculation method without any of its disadvantages.

The need to designate the ideal beneficiary and elect the most favorable distribution method no longer exists. Everyone gets favorable treatment because the new rules automatically extend the advantages of the former law’s minimum distribution incidental benefit rule to all participants and IRA owners and their designated beneficiaries. As a result, everyone gets a longer distribution period and a lower income-tax liability.

Regardless of how long a participant or IRA owner lives, the account balance is not exhausted provided the investment results are positive and the annual distributions are limited to the mandatory minimum amounts.

Since the length of the distribution period is not based on the beneficiary’s age, the participant has the freedom to designate an elderly relative or charity as beneficiary without fear of shortening the distribution period or incurring a higher income-tax liability.

Under prior rules, a surviving spouse whose age was close to that of the participant was required to exhaust the account balance within 26 years of the required beginning date. The new method is structured such that the life-expectancy factor never goes below 1.8—even if the participant was 125 years old. As a result, there is no forced liquidation of the entire account balance during a participant’s lifetime.

An exception. Participants may use an alternate distribution method when their sole designated beneficiary is a surviving spouse who is more than 10 years younger. In that case, the distribution period is the longer of a) the participant’s life expectancy under the uniform method described above or b) the joint life expectancies of the participant and his or her spouse, based on their attained ages in the year distributions take place.

DEATH WITHOUT COMPLICATIONS

The distribution schemes for postmortem distributions vary depending on whether the plan participant or IRA owner died before or after the required beginning date. If death occurred precisely on the required beginning date, the participant is treated as having died after the required beginning date.

The five-year rule requires that the entire account balance be distributed to the designated beneficiary by December 31 of the fifth calendar year following the participant’s death. Distributions need not be equal or periodic so long as the entire balance is exhausted on or before the end of the fifth year.

The new rules clarify that the five-year rule is mandatory in these three situations:

The decedent failed to designate a qualified beneficiary.

The decedent designated multiple beneficiaries including a charity or nonqualified trust, but the decedent (or his or her estate) did not establish separate accounts by December 31 of the calendar year immediately following his or her death.

An individual beneficiary—who is not the surviving spouse—failed to take the first distribution by December 31 of the calendar year immediately following the participant’s death.

The single life expectancy method stretches distributions over the beneficiary’s life expectancy, which is calculated based on the beneficiary’s attained age on his or her birthday in the year after the participant’s or IRA owner’s death. The first distribution must take place by December 31 of the calendar year immediately following the participant’s death.

Example 3. Adam Smith died on May 1, 2001, at age 69, leaving his granddaughter Ann as the sole beneficiary of his IRA. If Ann reaches age 5 on July 4, 2002, her single life expectancy from the IRS table is 76.6 years. If Adam’s IRA balance is $650,000, Ann’s required first-year distribution will be $8,485.64 ($650,000 divided by 76.6). In each subsequent calendar year, Ann will have to reduce her life expectancy by a full year for distribution purposes.

A surviving spouse who is the sole designated beneficiary may elect among the following options:

To take distributions under the five-year rule, as described above.

To defer distributions until the participant would have reached age 70 12 .

To roll over the decedent’s account balance into a new or existing IRA.

If the surviving spouse elects the second method, distributions must be made over his or her life expectancy, recalculated annually. When the surviving spouse dies, the remainder of the account is paid out over his or her remaining life expectancy, computed using the age he or she attained on the birthday in the year of death. The beneficiary named by the surviving spouse is not permitted to recalculate the surviving spouse’s remaining life expectancy.

As a general rule, the surviving spouse should elect the rollover method because it is flexible and has the best opportunity for tax deferral. The new regulations clarify that the surviving spouse may roll over all or part of the remaining account balance into his or her own IRA or redesignate the decedent’s account in the surviving spouse’s name as owner and not as beneficiary.

Death after required beginning date. The distribution methods here are similar to those described above when death occurs after the required beginning date. The main difference is the five-year rule does not apply.

When there is no designated beneficiary, the distribution period is the participant’s remaining life expectancy. An individual designated beneficiary, including the surviving spouse, may stretch out the distribution period based on his or her own single life expectancy. Again, the surviving spouse will benefit more by rolling over the plan assets into a new or existing IRA.

RELIEF!

The new regulations offer great relief to taxpayers and CPAs who felt frustrated and befuddled by the prior regulations. Not only have the new rules significantly simplified the distribution procedures, they also give taxpayers the flexibility they need and extend the distribution period. With the issuance of these rules, the Treasury Department has reduced the tax and compliance burden for the many U.S. taxpayers who own or inherit IRA or qualified plan balances.