Life Simplified and Sweetened—Sweeping Changes for IRAs and Retirement Plans
by: James Lange, CPA, JD

It’s Christmas all over again for IRA owners and participants in employer sponsored retirement plans such as 401(k)s, 403(b)s, etc.  Without bothering to consult the president or the Congress, the IRS has made sweeping changes in the rules governing the distributions of IRAs and retirement plans both when the IRA owner reaches 70 ½ and after the IRA owner dies.

Though billed as “New Proposed Regulations on Required Minimum Distributions” for all practical purposes the new rules are effective immediately.  (The previous set of proposed regulations in this area, passed in 1987, were never made final but practitioners have followed the proposed regulations as the law since 1987.)  The IRS has said “IRA owners may therefore rely on these proposed regulations for distributions for the 2001 calendar year.”   However, IRA owners may continue to use the existing rules for the year 2001.

If you are interested in learning what your new Minimum Required Distribution is, please visit my new Minimum Required Distribution Calculator. Calculating your MRD for 2001 according to the new regulations can be done simply by plugging in two entries: your date of birth and the combined balance from your IRA and retirement plans.

As I and other IRA experts have more time to read and interpret the 108 pages of proposed regulations, I will be sending out more information.  In the meantime, here is the “meat” of the new proposed legislation:

Background

Until now IRA owners and/or participants in most retirement plans were subject to extremely complex rules stipulating how much money they were required to withdraw from their IRA or retirement plan.  The minimum required distributions for IRA owners commenced when they reached 70 ½.  Some retirement plan participants could delay their required minimum distributions until after they retired.  Distributions from an IRA or retirement plan are taxable for federal income tax purposes. Given that, IRA owners who did not have an immediate need for the IRA distribution had a huge incentive to do everything they could to lower their required minimum distribution.

The amount of the minimum required distribution was calculated by dividing the balance in the account on December 31 of the previous year by a number derived from the life expectancy of the owner and the beneficiary.  There were different methods of calculating life expectancy including the recalculation method, the term certain method and even a hybrid method.  The minimum required distribution differed substantially depending on who was named as the primary beneficiary.  To make matters worse, once these elections were made, the IRA owner set in stone a distribution pattern that could not be slowed down after April 1 of the year following the year the IRA owner turned 70½.  If the surviving spouse was named the primary beneficiary but predeceased the owner, there was usually a massive acceleration of taxes both at the first and second death.  It was a mess.

New Law

The concepts of recalculation and term certain and hybrid with respect to calculating life expectancy are now only of historical interest.  With only one exception, the minimum required distribution is calculated based on the joint life expectancy factor of the IRA owner, starting at age 70, and the life expectancy of someone who will be considered to be ten years younger than the IRA owner.  That life expectancy factor will decrease as the IRA owner ages.  “Using the MDIB table, most employees (the IRS also includes  IRA owners) will be able to determine their required minimum distribution for each year based on nothing more than their current age and their account balance as of the end of the prior year (which IRA trustees report annually to IRA owners.)” The only exception is when your spouse is 10 or more years younger than you are.  In that case, the IRS will allow you to use your actual joint life expectancy. Most participants who currently receive required minimum distributions will now be able to enjoy a lower required minimum distribution using the MDIB. As I mentioned above, you can easily calculate your new MRD with the my new calculator.

Minimum Required Distributions After the Death of the IRA Owner

The old rules in this area were really a mess.  The general objective for beneficiaries who did not immediately need the proceeds of the inherited IRA was to comply with the rules to achieve a “stretch IRA.”  That is, planners strived to have the beneficiaries retain funds in the IRA for as long as possible after the owner died. Planners had to take into consideration a variety of factors including the named beneficiary when the owner turned 70 ½, whether the surviving spouse predeceased the IRA owner, and whether a special election that had to be made by either the surviving spouse or nonspouse beneficiaries was filed in a timely fashion.  Pitfalls and possibilities for extremely costly mistakes were a part of the treacherous quagmire of planning for individuals with substantial IRAs.

Under the new rules:

• If the beneficiary is the surviving spouse, the rules about making an IRA rollover into the spouse’s own IRA are clarified. 
• If the beneficiary is a non-spouse, they will be required to take minimum required distributions over their life expectancy. 

Timing of Determination of Beneficiary

We no longer have to worry about who was or was not the named beneficiary on April 1 of the year following the year the IRA owner turned 70 ½. The life expectancy of the beneficiary is determined after the IRA owner dies. It is not dependant on who or how old the beneficiary was when the IRA owner turned 70½.  In the words of the IRS “the designated beneficiary is determined as of the end of the year following the year of the employee’s death rather than as of the employee’s required beginning date or date of death.”

The new law invites “disclaimer planning” opportunities.  In the past I have written extensively about disclaimer planning and now more than ever disclaimer planning will be a significant strategy for individuals with substantial IRAs.  Previously, as a planner for larger estates with significant IRAs, I often advocated breaking up a large IRA into several separate IRAs. The smaller separate IRAs would name children and/or grandchildren as beneficiaries to take advantage of tax deferred “stretch” of the IRA.  (In fact, these changes will require me to rework many of my existing articles, including one that was just submitted to the AICPA for peer review that had an in depth quantitative analysis of the old rules.)  Now, since the critical date for determining the distribution pattern for the beneficiary is after the IRA owner dies, we could achieve the same benefits of the “stretch” IRA by disclaimer.

Under the new laws, after the death of the IRA owner the surviving spouse could disclaim to the children and the children could take minimum required distributions based on their life expectancy.  If the children were named beneficiary, the children could disclaim to their children for a longer “stretch” or deferral period.  This offers the family an opportunity to evaluate their long-term financial picture and potentially enhance their picture with the possibility of a “stretch IRA.”

A Little Bit of Fun

Since the changes have come out, I have contemplated  the benefits of “cascading beneficiaries” with disclaimer options. To begin we set up the basics. The primary beneficiary is the surviving spouse.  The contingent beneficiary is a trust where the surviving spouse receives the income and, at the second death, the funds are distributed to the children.  Upon the death of the IRA owner, the spouse could rollover the IRA to his/her name.  Then at 70 ½, when he/she is required to begin taking distributions, the minimum required distribution (MRD) could be based on his/her life and the life expectancy of a beneficiary assumed to be 10 years younger.

The idea of  “cascading beneficiaries” builds on the basics as follows:

The primary beneficiary of the IRA could be the surviving spouse.  The secondary or first contingent beneficiary could be a trust where the surviving spouse gets the income and at the death of the surviving spouse the proceeds go to the children equally.  The third beneficiary or second contingent beneficiary would simply be the children equally.  The fourth or third contingent beneficiary could be a trust for the grandchildren.

Under the old rules you could have cascading beneficiaries but it was not helpful in terms of slowing down the minimum required distribution of the beneficiary because the critical date for naming a beneficiary was April 1 of the year following the year the IRA owner turned 70 ½.  Under the new rules the critical date is December 31 of year following the year the IRA owner dies. The extended time frame allows a family to leave options open for getting the longest “stretch IRA” but should circumstances dictate, it also preserves the safety net for the natural heir of the IRA owner, i.e., the surviving spouse.

In addition, Roth IRA owners will benefit by extending the deadline for determining the beneficiary to December 31 of the year after the Roth IRA owner’s death.

What’s the Catch?

These are all extremely favorable changes.  But, it isn’t the IRS’s habit to confer a second Christmas in January.  The catch is that since it is so easy to calculate the minimum required distribution the IRS is going to require the investment company that is holding your IRA (like Vanguard or Merrill Lynch or a bank) to report your projected minimum required distribution. Then, if you fail to take and pay income tax on the required minimum required distribution  (which they will know because they will crosscheck the information Vanguard sends them with your tax return—much the way they currently crosscheck interest income), you are likely to be hit with a 50% penalty on the amount not withdrawn.  Though this penalty has been on the books for a long time, the IRS could not enforce the required minimum distribution rules or the penalty for failing to make the required minimum distribution because the calculation of the required minimum required distribution was so complex.

The rules governing annuities will not change substantially. The old rules will continue to apply.

However, for IRA owners who comply with the law, there is really no downside.  Of course with new opportunities, it is possible, even likely, that a review of your retirement and estate plan and the beneficiary designations of your IRA or retirement plan will allow you to take full advantage of the benefit from the changes.

James Lange is a tax attorney and CPA who provides specialized retirement and estate planning services to same sex couples with significant retirement plan accumulations.  He has prepared over 450 simple and complex retirement and estate plans.  These plans include tax-savvy advice, will and trust preparation, and sophisticated beneficiary designations for IRAs and other retirement plans. You can contact Jim by phone at (800) 387-1129, or (412) 521-2732, or by e-mail at admin@outestateplanning.com.