Tax Planning with the New Minimum Distribution Rules

By Ron West

In Brief

Tax Simplification that Makes Sense

In January 2001, new and proposed regulations on required minimum distributions under IRC section 401(a)(9) heralded a far-reaching overhaul of existing rules for distributions from IRAs and amended qualified plans. The old rules remain in place for distributions from qualified plans that are not amended to incorporate the new rules. The new rules simplify and streamline the complex rules and elections that have confused retirees and professionals alike. In most cases, the new rules reduce required minimum distributions and remove many of the old rules' traps for the unwary, the careless, and the procrastinator. The author summarizes the new rules for participants in qualified plans and individual IRA owners.

The new minimum distribution rules announced in January 2001 apply to qualified plans under IRC section 401(a) and to individual retirement plans. Roth IRAs are not subject to minimum distribution rules while the account owner is alive, but beneficiaries become subject to the rules after the owner's death. The rules also apply to certain tax-deferred plans and contracts under IRC section 403(b) and deferred compensation agreements under IRC section 457.
The new rules, promulgated as proposed regulations, became effective on January 1, 2002, for distributions made for 2002 (see the Sidebar, "Changes to the Minimum Distribution Rules"). For 2001, earlier application of the rules for IRAs was optional, and plan documents did not have to be amended. For 2001, IRA participants could compute the minimum required distribution under both the old rules and the new rules and withdraw the smaller amount. The final regulations will not be retroactive if they are more restrictive than the proposed regulations.

Qualified Plans

Unlike IRA owners, participants in qualified plans did not have an automatic option to apply the new rules immediately in 2001. Moreover, the new rules do not apply to qualified plans unless the plan sponsor adopts the model amendment language set forth in the preamble to the regulations. Adoption is not mandatory until the regulations are finalized and become effective; until then, the old set of rules on minimum distributions continues to apply. Participants in unamended qualified plans that wish to benefit immediately from the new rules should consider a direct rollover, as permitted, to IRAs. Participants in unamended qualified plans that have already received a required minimum distribution (RMD) under the old rules may roll over the difference between the old and new rules' distributions into an IRA for the following year and avoid tax on the excess amount, as long as they act within 60 days of receiving the RMD. The excess amount rolled over would be included in the RMD computation for the rollover year and subsequent years.

Beneficiary Designation

Under the new rules, the required beginning date (RBD) no longer serves as a deadline to designate a beneficiary and to select a distribution method (see the Sidebar, "RBD for Distributions"). Elections and clerical errors can now be corrected on a prospective basis. Under the old rules, the choice of beneficiary and distribution method determined the payout period and RMD before and after the participant's death (except in the case of a surviving spouse beneficiary, who had more distribution options). Once made, by the participant or by default, these decisions were irrevocable after the RBD or the death of the participant (unless a new designated beneficiary had a shorter life expectancy). Under the new rules, the RBD is still the deadline to begin withdrawals, but beneficiaries can be designated and changed anytime until death, and final determination of the designated beneficiary is not settled until December 31 of the year following the year of the participant's death.

Under the new rules, a participant can designate a beneficiary at any time and as often as desired without affecting lifetime minimum distributions. For example, a participant may first name her son as beneficiary. If she later learns that he does not need the money, she can switch the designation to a grandchild. Although neither beneficiary is factored into the lifetime distribution, the younger grandson will receive a longer payout period after the participant's death.

The payout period for all lifetime distributions is now based upon a single uniform table. The new rules should facilitate charitable giving, because the same single uniform table also applies when a charity is named as a beneficiary. The only time a designated beneficiary affects the payout period for lifetime distributions is when the sole designated beneficiary is the participant's spouse and is at least 10 years younger than the participant. Naming such a spouse results in a longer payout period under existing joint and last survivor life payout tables and a smaller RMD while the participant is alive.

It is still important for participants to name a designated beneficiary or beneficiaries and contingent beneficiaries when the account is established, or as soon as possible afterwards, in order to take advantage of longer possible post-mortem payout periods and planning opportunities. Naming beneficiaries is not allowed after the participant's death. If no beneficiary has been designated, either by the participant or default plan provisions, the participant is considered to have no designated beneficiary, and stricter distribution rules apply.

Under the new rules, a designated beneficiary need not be identified by name if the individual can be identified as the beneficiary by December 31 of the year following the year of the participant's death. Where there are several named designated beneficiaries, any named beneficiary who is cashed out or eliminated by disclaimer (or otherwise) by December 31 of the year following the year of the participant's death is disregarded in determining the designated beneficiary as of that date. The deadline to determine the designated beneficiary effectively falls on the same date as the deadline for making the first required distribution to the designated beneficiary.

A Single Uniform Payout Table

The new rules greatly simplify the RMD computations. One uniform payout table based solely on the participant's attained age in the year of distribution is prescribed for all lifetime distributions to the participant, whether or not a beneficiary has been designated (including a spouse) and regardless of the participant's health. The lone exception is where the spouse is more than 10 years younger than the participant. The uniform payout table eliminates the confusion that arose under the old rules. The uniform table is identical to the MDIB table previously used under the minimum death incidental benefit distribution rules.

The new uniform table for lifetime distributions incorporates a recalculation of life expectancy whereby the payout period each year is redetermined based upon the participant's age. Term-certain is no longer an option for lifetime distributions. The uniform table reduces the impact of the passage of time and eliminates the possibility that the participant will outlive the account. As long as the participant is alive, there will always be a remaining life expectancy. For example, a participant with an attained age of 100 will have a remaining life expectancy of 5.7 years; one at age 110 has 2.8 years. The rules for distributions after the participant's death specify whether the term-certain or the recalculation method applies.

Minimum distributions must be made by the RBD and by December 31 of each year thereafter. Although the rules mandate the minimum amount that must be distributed, participants and beneficiaries can always withdraw greater amounts, up to the entire account balance.

Example. Joe turned 70As in 2001. He must begin receiving distributions by April 1, 2002. Joe's IRA account balance as of December 31, 2000, is $50,600. Based upon his age of 71 on December 31, 2001, the payout period under the new uniform table is 25.3 years. The RMD for 2001, Joe's first distribution year, is $2,000 ($50,600 divided by 25.3). This amount must be withdrawn by April 1, 2002. The required distribution for the following year, 2002, must be withdrawn by December 31, 2002. It is based on the reported account balance as of December 31, 2001, minus the $2,000 distribution made in 2001 for 2000, divided by 24.4 (Joe's redetermined payout period).

Another table, based on the joint and survivor life expectancies of the participant and spouse, is used when the sole designated beneficiary for the entire year is a spouse more than 10 years younger than the participant. The payout period is redetermined each distribution year based upon the ages of the participant and the spouse. The payout period will be longer than the payout period that would be used under the uniform table and will result in a lower RMD.

Example. In 2001, Sam is 71 years old. His payout period under the uniform table is 25.3 years. If, however, his sole designated beneficiary is his spouse, who is 60 years old, a longer payout period of 26 years is used to compute the RMD for 2001. The younger the spouse, the longer the payout period. If the spouse is 56 years old, the payout period becomes 29.0 years; if 51, 33.0 years. The younger spouse must be the sole designated beneficiary for the entire year. Should the younger spouse die while the participant is alive, or be replaced by another beneficiary, then the participant must revert to the uniform table in that year. Similarly, a participant who marries, or designates, a younger spouse cannot use the joint and survivor table, but may do so in the following year. If the younger spouse is only one of several designated beneficiaries, the joint and survivor table cannot be used. Participants that intend younger spouses to benefit from IRAs and qualified plans should designate them as beneficiaries.

Any balance remaining in an IRA or qualified plan account after the participant's death must be paid out within a certain period. The applicable rules have been simplified greatly and they no longer depend upon the distribution method elected by the participant before the RBD. Any distribution to the participant required in the year of death must be made before determining the amount available to the beneficiaries and the beneficiaries' RMD.

Under the new rules, the RMD after the death of the participant hinges on whether a designated beneficiary was named and whether the participant died before or after the RBD. The IRS has clarified that, even where the participant has died before 2001, post-death RMDs can be computed under the new rules. More flexible distribution options are available to a designated spouse beneficiary.

When the participant dies after the RBD and a non-spouse beneficiary has been designated, the remaining account balance must be paid out over the remaining life expectancy. The first distribution is required by December 31 of the year following the year of participant's death. The payout period is calculated from the beneficiary's age in the year following the year of the participant's death. In each subsequent year, the payout period is reduced by one (the term-certain method). When the participant dies before the RBD and a non-spouse beneficiary has been designated, the RMD generally follows the same default rule described above.

When there is no designated beneficiary by December 31 of the year following the year of the participant's death, the RMD depends upon whether the participant died before or after the RBD. When the participant dies before the RBD, the entire account balance as of December 31 of the year of death must be distributed by December 31 of the fifth year after participant's death. This situation occurs if there is no designated beneficiary named by either the participant or default plan provisions; if a charity, estate, or other non-individual is named a beneficiary; or if a trust fails to satisfy certain specified requirements. When the participant dies after the RBD, the account balance (after the RMD is made for the year of death using the uniform table) must be distributed over a payout period based on the participant's age in the year of death, using the single life expectancy table and reduced by one for each subsequent year. The first distribution must be made by December 31 of the year following the year of the participant's death.

As in the past, more distribution options are available to a spouse who is the sole designated beneficiary. When the surviving spouse is not the sole designated beneficiary, the computation of RMD follows the rules for non-spouse designated beneficiaries; therefore, the IRA should be split into separate shares so that the surviving spouse is treated as a sole beneficiary. If the participant dies before the RBD and the spouse is the sole designated beneficiary, the RMD must begin by December 31 of the year in which participant would have turned 70As . While the surviving spouse is alive, the payout period is redetermined each year based upon the spouse's age.

If the participant dies after the RBD and the spouse is the sole designated beneficiary, the distributions must begin by December 31 of the year following the year of the participant's death; the payout period is redetermined each year based upon the spouse's age. When the spouse dies, the payout period for determining RMD thereafter is based on the spouse's age in the year of death, reduced by one each year thereafter. This rule is used regardless of whether the participant died before or after the RBD.

A spouse who is the sole designated beneficiary of a participant's qualified plan account or IRA can roll over the IRA or qualified plan account. Any rollover should be a direct one in order to avoid a 20% withholding tax. It must be completed within 60 days of distribution. In the case of IRAs, spouses can also elect to treat decedents' IRAs as their own, but only if they are the sole designated beneficiaries and have unlimited rights to withdraw amounts from the IRAs. The election is permitted only after any distributions required for the year of the participant's death.

Exercising an election avoids the minimum distribution rules applicable to the participant. There are three important advantages to making the spousal rollover or election: First, surviving spouses can name their own beneficiaries, possibly resulting in a longer payout period. Second, the RBD is now determined by the year in which the surviving spouse attains 70As . When the surviving spouse is younger than the decedent, the RMD will start later and taxes will be deferred longer. Third, the spouse becomes the owner of the account. Upon reaching the spouse's RBD, the RMD is computed using the uniform payout tables, not the single life expectancy table that would apply if the rollover or election were not made.

The election to treat the participant's IRA as the spouse's is made by failing to withdraw the RMD when due, by contributing to the IRA, or by redesignating the IRA in the spouse's name. Contrary to earlier private rulings, the new rules do not allow surviving spouses, as the beneficiaries of trusts that are the beneficiaries of IRAs, to elect to treat decedents' IRAs as their own, regardless of whether they are deemed the sole beneficiary of the trust and regardless of how much control the trust gives to them.

A designated beneficiary is any natural person who is chosen as such before the participant's death, either by the participant's affirmative election or the default terms of the IRA or qualified plan, and who continues to remain a designated beneficiary as of December 31 of the year following the year of the participant's death. When there are two or more designated beneficiaries at this date, the new rules adopt the same approach as the old rules. If the account has not been divided into separate accounts or shares, the beneficiary with the shortest life expectancy (i.e., the oldest) is treated as the designated beneficiary.

Non-individual beneficiaries (e.g., estates, corporations, charities) cannot be designated beneficiaries. Similarly, if an entity is one of several designated beneficiaries as of December 31 of the year following the year of the participant's death, the IRA or qualified plan is treated as if there is no designated beneficiary for RMD purposes. Where an entity is the designated beneficiary, the RMD will not be affected during the participant's lifetime, but will be affected after death. Where a trust is named as a beneficiary, it can be treated as the designated beneficiaries if certain requirements are satisfied as of December 31 of the year following the year of the participant's death.

Post-mortem Planning

Because the determination of designated beneficiaries is not finalized until December 31 of the year following the year of the participant's death, the new rules make IRAs and qualified plans a more powerful post-mortem tax and estate planning tool. During this time window, disclaimers and distributions of benefits (cash-outs) can be used to eliminate one beneficiary in favor of another. Any beneficiary so removed is disregarded when determining the designated beneficiaries for RMD purposes. To provide flexibility in passing an account balance to other beneficiaries with possibly longer payout periods, participants should name primary and contingent beneficiaries when accounts are first established, or as soon as possible. Although disclaimers for the purposes of the RMD rules can be made up until December 31 of the following the year of the participant's death, qualified disclaimers under IRC section 2518 must be made no later than nine months after the participant's death and must meet certain other requirements. A qualified disclaimer is not treated as a transfer for gift, estate, or generation-skipping tax purposes. An unqualified disclaimer is treated as a transfer, that is, a gift of the disclaimed interest to the recipient. Disclaimers can be used to shift benefits from one beneficiary to a more needy one, to extend the RMD over a longer period, and to accomplish traditional post-mortem estate planning as it relates to the marital deduction, unified credit, charitable giving, and desirable redistributions of wealth.

Where one of the designated beneficiaries is an entity and a disclaimer is not an option, it may be possible to arrange a distribution of its respective interest to the entity before the December 31 deadline. For example, a participant designated his favorite charity and his child as equal primary beneficiaries of his IRA. The charitable beneficiary may be cashed out shortly after the participant's death through a payment of its interest in the IRA. None of the distribution is taxable to a qualifying charity. Once the charity is cashed out, the child is left as the sole designated beneficiary and his life expectancy can be used to compute the RMD. Had the charity not been cashed, there would be no designated beneficiary and the entire account would have to be distributed either over the participant's life expectancy (if he died after the RBD), or within 5 years of death (if he died before the RBD).

Establishing separate IRAs before the December 31 deadline can accomplish several post-mortem objectives. Typically, separate accounts are established by dividing an existing IRA via a direct transfer to new accounts based on each beneficiary's interest. Separate accounts require that all transactions, such as gains, losses, contributions, and forfeitures, be accounted for and allocated pro rata. Each account should be treated independently for all purposes. To avoid full distribution treatment when an account is split, the separate account must continue to remain in the name of the deceased account owner. The beneficiary, however, controls investment decisions and distributions, and distributions are reported under the beneficiary's Social Security number.
The multiple beneficiary rules, which require the RMD to be based on the age of the oldest designated beneficiary, can be avoided with separate accounts. Beneficiaries can independently elect to withdraw the RMD over their individual life expectancy, or accelerate withdrawals, without affecting the RMD pattern for other beneficiaries. Each beneficiary can also direct individual investment decisions.

Establishing separate accounts can also be helpful when a surviving spouse is one of several beneficiaries. As described above, surviving spouses can roll over the decedent's account or elect to treat it as their own. Although the new rules expressly allow for separate accounts to be established by December 31 of the year following the year of the participant's death if this is before the RBD, further guidance is expected as to whether this applies if the participant dies after the RBD.

Reporting and Compliance

IRC section 4974 imposes an excise tax of 50% on any shortfall between the total RMD for all accounts and the total amount actually withdrawn. In the past, it was difficult to police this penalty and it was rarely imposed, mainly because the IRS was not apprised of the RMD; only amounts actually withdrawn had to be reported. Under the new rules, however, IRA custodians and trustees will also be required to report the annual RMD to the IRS and to distributees. Such reporting does not begin before 2002 and does not apply to qualified plans. As under the old rules, the RMD is computed separately for each IRA. Under an aggregation rule, the annual total RMDs for all IRAs can be withdrawn from any one or several IRAs, as desired. The aggregate rule applies separately to all IRAs held as an owner and to all IRAs held as beneficiary of the same decedent. RMDs from qualified plans cannot be aggregated.

The new rules greatly simplify the RMD calculations during and after the participant's life. In most cases, the RMD will be smaller, reducing current taxation and increasing deferrals. The need to make irrevocable decisions and beneficiary designation before the RBD is eliminated. To facilitate post-mortem planning, it is wise to name primary and contingent beneficiaries when accounts are established and before death.

©2002 CPA Journal. Legal Notices