Required Distributions from Qualified Plans and IRAs

By Marvin R. Rotenberg

Options Available When You Reach 701*2.

Qualified retirement plans and IRAs are vehicles used to build up tax deferred assets. However, at age 701*2, minimum annual distributions must be made from such plans. The required minimum distribution is determined by dividing the plan balance at the end of the previous year by a life expectancy factor. In addition to choosing the formula and the resulting factors to calculate the required minimum distribution, a method must be selected.

The IRS permits three such methods:

* Term Certain--Assumes the life expectancy is fixed during the year the participant attains age 701*2.

* Dual Recalculation--Assumes the life expectancy changes each year.

* Single Recalculation--A hybrid of the other two.

Once a method is determined by April 1 of the year following reaching 701*2, it cannot be changed.

The author has included an exhibit that lists the advantages and disadvantages of each method and provides an example that compares the results of the three methods.

The longer you can keep funds in your IRA or employer plan without withdrawing them, the more money you can accumulate tax-free for your retirement years and, ultimately, for your heirs. However, the tax law does not allow you to delay the start of distributions indefinitely.

When you reach age 701*2, you must begin to receive minimum annual distributions from your plan. The IRS has established a series of complex rules for determining the required minimum amount you must receive each year. Penalties can be imposed by the IRS if the rules are not followed. The distribution methods are the same for IRAs as for qualified employer plans, with three exceptions.

Qualified Plan Exceptions

Participants in a qualified plan who made a special election under TEFRA section 242(b)(2) prior to January 1, 1984, do not have to take required minimum distributions until they actually retire. The Small Business Job Protection Act of 1996 allows participants in qualified plans to defer taking minimum distributions until they retire, as long as they do not own five percent or more of the company. For participants in 403(b) plans, which produce what are commonly known as tax deferred annuities (TDAs) and tax sheltered annuities (TSAs), contributions prior to 1987, if they can be identified, do not have to be used for calculating distributions at age 701*2. Only contributions prior to 1987 can be sheltered, not the earnings. At age 75, pre-1987 contributions have to be added to the then market value to calculate minimum distributions.

Choice of Lives

Once a participant attains age 701*2, there are several complex rules and various choices to be made affecting the amount of required minimum distributions. If a participant's entire interest is not paid by the required beginning date, April 1st of the following year in which the participant attains age 701*2, payments must be made either over the participant's lifetime, the lifetimes of the participant and a designated beneficiary, or over a period not exceeding the participant's life expectancy or the joint life expectancies of the participant and a designated beneficiary.

Designated Beneficiaries

A plan participant has the option of naming a designated beneficiary or a nondesignated beneficiary. The distinction between a designated and nondesignated beneficiary is important because a nondesignated beneficiary does not allow the use of a joint life expectancy between the IRA participant and the beneficiary. Individuals are considered designated beneficiaries because individuals have a discernible life expectancy under IRS life expectancy tables. The participant can use a single or joint life expectancy in determining the correct required minimum distributions (RMD). When using a joint life expectancy, if there is more than one designated beneficiary, the age of the oldest beneficiary must be used.

Calculating the Amount

To calculate the required minimum distribution, the prior December 31 value is used. Once a participant's December 31 balance is determined, this balance is divided by the appropriate life expectancy figure determined in accordance with IRS life expectancy tables. If the participant has no beneficiaries listed on the Designation of Beneficiary form, a single life expectancy must be used.

The following formula expresses the calculation in a simple manner:

Required

Mininimum = Planned Balance

Distribution Life Expectancy

When planning to withdraw money from an IRA, 401(k) Plan, or other qualified plans at age 701*2, there are three methods that can be used to determine the required minimum distributions. Each method has its advantages and disadvantages depending on an individual's own circumstances. This being a critical election and the methods of distributions not generally understood, it's important to understand the three methods, their advantages and disadvantages.

A participant in a qualified plan or IRA is required to begin taking minimum distributions (withdrawals) in the year they reach age 701*2 (unless they qualified for one of the exceptions noted above); however, the first year's distribution may be deferred until April 1 of the following year. If the first year's required minimum distribution is postponed, two distributions would have to be made in the second year, the second no later than December 31. The amount of the annual minimum distributions is determined by one of several methods prescribed by the IRS. The participant may choose one of these methods at any time prior to April 1 following the year that the participant reaches age 701*2. The selection of one of the three distribution methods becomes an irrevocable election on April 1 following the year a participant attains age 701*2 and cannot be changed.

Each of the distribution methods is based on life expectancy calculations for the participant and any designated beneficiaries. The first method, term certain, assumes the life expectancy is fixed during the year the participant attains age 701*2. The second method, dual recalculation, assumes the life expectancy changes each year. The third method is recalculation of one life and term certain on the other.

Term Certain Method. Upon reaching age 701*2, the participant can elect to use a single or joint life expectancy, assuming a designated beneficiary is the primary beneficiary. The IRS views the use of a single life when there is a designated beneficiary as simply taking more than the required minimum distribution. Based on the ages of the participant and designated beneficiary, their joint life expectancy is determined by consulting the life expectancy tables contained in Treasury Regulation section 1.72-9. For example, a 70-year-old participant and a 69-year-old beneficiary have a joint life expectancy of 21.1 years according to the life expectancy charts. This becomes the "term certain" period; life expectancy is determined in each subsequent year by subtracting one year. By the end of the 21.1 year term, all the money in the participant's account would be withdrawn.

The term certain method results in a guaranteed payout period that could survive the death of the parties. For example, if the designated beneficiary predeceases the participant, the participant can continue to use the term that still remains. In the example noted earlier, the participant and designated beneficiary had a joint life expectancy of 21.1 years. At the death of the designated beneficiary, the participant can continue to use the remaining term. Assuming designated beneficiary dies after 10 years (21.1-10), the participant can continue to withdraw the required minimum distributions over the remaining 11.1 years.

Dual Recalculation Method. In each subsequent year after the first year of distribution, the participant must consult the life expectancy table and redetermine his or her single or joint life expectancy. Under the recalculation method, a participant and beneficiary can basically stretch out required minimum distributions for the rest of their lives. The life expectancy period does not decline by one each year, it declines more slowly. For example, in the previous example the participant and beneficiary who had a joint life expectancy of 21.1 years in the first year, will have a joint life expectancy of 20.2 years in the second year. The life expectancy table extends to age 115.

Required minimum distributions under the recalculation method can be spread over a significantly longer period of time, resulting in a lower withdrawal, thus allowing a larger amount to continue to earn income on a tax deferred basis. However, if the participant's designated beneficiary predeceases the participant, the joint life expectancy of the participant will revert to a single life expectancy in the calendar year following the year of death. A participant at age 74 and designated beneficiary age 70 have a joint life expectancy of 19.1 years according to the life expectancy table. If the spouse dies when the participant is 74, the participant would have to use a single life expectancy of 10.6 the next year, thus accelerating distributions. The dual recalculation method cannot be used for anyone other than a spouse.

Single Recalculation Method. An alternative to using either dual recalculation or term certain method on each life is to recalculate the participant's life expectancy but not the life of the designated beneficiary's. Use of this method combines the advantages of each of the other two methods. Using this hybrid method, if the designated beneficiary dies before the participant, the participant is permitted to continue using the joint life expectancy and will not have to accelerate required minimum distributions. This hybrid method will stretch payments over a longer period than using term certain on both lives. In most cases recalculating only the participant's life and not the beneficiary's probably achieves the best overall results.

While this hybrid method may provide the best overall result, it is often not used because it is complex to administer and generally not understood.

MDIB Requirement. All of the methods of determining joint life expectancy are subject to the Minimum Distribution Incidental Benefit (MDIB) requirement during the participant's lifetime. This requirement limits the age difference between the participant and a nonspouse beneficiary to only 10 years regardless of their actual age. The MDIB requirement is not applicable in the years following the participant's death.

Default Methods. Usually, the IRA document will indicate what default method is to be used if an election was not made. In the absence of a stated default method in the IRA document and if no election was made by the participant, the default method is dual recalculation. The vast majority of all IRA documents default to dual recalculation because it is perceived to be the most conservative. While the law permits an IRA to provide for each of the distribution methods described above, some IRA documents limit a participant to only some of those methods. So, the IRA document must be examined to determine which methods are available.

One Size Does Not Fit All

Selecting a method of distribution prior to April 1st of the following year a participant attains age 701*2 is extremely important and should not be taken lightly. If a participant defaults into a method or selects a method at age 701*2, it cannot be changed in subsequent years. The right method for each individual will depend largely on his or her financial and personal situation. One size does not fit all individuals nor does one method fit each individual's own personal and financial situation. Exhibit 1 summarizes the advantages and disadvantages of each method. Exhibit 2 compares the three methods assuming a seven percent annual total return and life expectancies of 70 and 67 years for the participant and beneficiary respectively. *

Marvin R. Rotenberg is national director, retirement services at The Private Bank at the Bank of Boston.