Manage your distributions wisely at 70 1/2. (minimum distribution rules) (Employee Benefit Plans)by Rotenburg, Marvin R.
Qualified pension, profit sharing, 403(b) plans, and IRAs, however, are required to completely distribute all of a participant's benefits or to begin minimum distributions by a required beginning date. These minimum distribution requirements are contained in IRC Sec. 401(a)(9) and Prop. Regs. Sec. 1.401(a)(9)-1, 1.401(a)(9)2, 1.403(b)-2 and 1.408-8.
Distributions must either be completed, or must begin, by the required beginning date. The required beginning date is generally April 1 after the calendar year in which a participant or IRA owner reaches age 70 1/2. There is a transitional rule involving qualified plans for a participant who is not a 5% owner and was 70 1/2 before 1988. The rule provides that the participant's required beginning date is April 1 after the year of retirement if that is later than the required beginning date.
Although the current required minimum distribution (RMD) rules were issued in 1987, their roots date back to TRA 84 and TRA 86 when Congress mandated new distribution rules for both qualified retirement plans and IRAs. In response to TRA 84 and TRA 86, the IRS released a proof comprehensive distribution regulations on July 27, 1987.
Enter John Smith
The minimum distribution rules do not operate until a participant's required beginning date. Payments may be made in any manner until that time. Payments due on or before the April 1 required be-ginning date are for the prior calendar year, i.e., the year in which the participant reached age 70 1/2. For example, ffJohn Smith, an IRA owner, was born on February 1, 1923, he will reach age 70 1/2 on August 1, 1993, and must begin receiving IRA distributions by April 1, 1994. Mr. Smith may take a required minimum distribution for calendar year 1993 either during 1993 or take it by no later than April 1, 1994. The calendar year in which Mr. Smith becomes 70 1/2 is called his first distribution calendar year. Mr. Smith is permitted to postpone the first calendar year's distribution in whole or in part until the following April 1st. Tax planning will dictate whether the deferral option, which is not available for any succeeding distribution calendar years, should be used. Thus, Mr. Smith's IRA distribution for 1994 must be made by December 31, 1994. If a taxpayer falls to receive a timely required minimum distribution, he or she is subject to an excise tax of 50% of the distribution shortfall.
If, in the above example, Mr. Smith is required to receive a minimum distribution of $20,000 for calendar year 1994 and only receives $10,000, the excise tax llability for 1994 is 50% of the $10,000 shorffall, $5,000. In addition to the penalty, Mr. Smith must pay income tax on the $20,000 even though he only receives $15,000 after the 50% penalty. The IRS may, however, waive the excise tax if Mr. Smith's shortfall was due to a reasonable error and he has taken steps to correct it.
Once a participant attains age 70 1/2, there are several complex rules and various choices to be made affecting the amount of the required minimum distribution. If a participant's entire interest is not paid by the required beginning date, 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.
Upon the establishment of an IRA rollover account, the IRA owner has the option of designating a beneficiary or beneficiaries. The IRA owner can use a joint life expectancy in determining the correct required minimum distributions. If there is more than one designated beneficiary of an IRA account, the age of the oldest beneficiary must be used. To calculate the required minimum distribution, the prior December 31 value is used. Once an IRA holder's December 31 balance is determined, this balance is divided by the appropriate life expectancy figure determined in accordance with Prop. Reg. Sec. 1.401 (a) (9)-1, table V and VI of Reg. Sec. 1.72-90. If an IRA holder has no beneficiaries listed on his or her IRA plan document, he or she would use his or her single life expectancy. On the other hand, if the IRA holder named one or more beneficiaries on the plan document, the joint life expectancy of the IRA holder and his or her oldest primary beneficiary would be used. To calculate the required minimum distribution (RMD), an IRA holder must divide his or her December 31 balance (from the preceding year) by the appropriate single or joint life expectancy.
A Simple Formula
The following formula expresses the calculation in a simple manner:
RMD = IRA Balance/Life Expectancy
Chart 1 illustrates the joint and survivor life expectancy using a spouse as the beneficiary. For example, let's assume Mr. Jones' December 31 IRA balance is $100,000. He has attained age 70 1/2, and his spouse, age 69, is his named beneficiary. Therefore, their joint life expectancy in the first-year of distributions is 21.1 years. Using the above formula, Mr. Jones' first year distribution would have to be $4,739,34, ($100,000/21.1). This amount must be paid out to Mr. Jones by no later than April 1 of the year following his 70 1/2 birthday.
As of January 1, 1989, the IRS adopted a new rule for determining RMDs of IRA holders with non-spouse primary beneficiaries. The Minimum Distribution Incidental Benefit rule (MDIB) requires IRA holders with nonspouse primary benefii ciaries to use a joint life expectancy no greater than the joint life expectancy of the IRA holder and an individual exactly 10 years younger than the IRA holder (Prop. Reg. Sec. 1.401 (a)(9)-2). In the past, many IRA holders would name young children as primary beneficiaries to obtain a smaller RMD. MDIB reinforces the IRS position that the primary purpose of an IRA is to provide retirement income for the IRA holder during his or her lifetime. According to the IRS, benefits going to an individual other than the individual for whom the lRA is maintained must be "incidental" or secondary' to the primary purpose of providing retirement income for the IRA holder. Using the above example, instead of Mr. Jones naming his spouse his primary beneficiary, he named his daughter, age 45. The MDIB would require Mr. Jones to use a joint life expectancy of his age 70 with one a fictitious person age 60. In this example, using the joint life expectancy table (life expectancies are determined under Tables V and VI of Reg. Sec. 1.72-9), the joint life expectancy would be 26.2 years. In this situation, his first-year minimum distribution would be $3,816.79 ($100,000/26.2).
Chart 2 illustrates the joint life expectancy using the MDIB rule. MDIB applies to all IRA holders who have one or more non-spouse primary beneficiaries named that are greater than 10-years younger, regardless of whether a spouse is also named as a primary beneficiary. However, the traditional joint life expectancy of the IRA holder and his or her spouse will generally be less than the applicable MDIB figure for the year.
An IRA holder is permitted to name a trust as the primary beneficiary of his IRA. However, when an individual names a trust as primary beneficiary of his or her IRA, such designation will often limit the IRA holder's right to use a joint life expectancy when determining RMDs. An irrevocable trust, meeting certain requirements, is an exception to the rule.
Using a single or a joint life expectancy will increase or decrease the RMD substantially. For example, an individual using a single life expectancy at age 70 (using table V of Reg. Sec. 1.72-9) would have a llife expectancy of 16 years. An individual using a joint life expectancy with a spouse one year younger would have a joint life expectancy of 21.1 years, and the same individual using the MDIB would have a joint life expectancy of 26.2 years. Using the example of the prior year balance being $100,000, minimum first year payments would be as follows:
Subsequent RMDs are determined the same way as the IRA holder's first- year RMD. Each year, the prior year's December 31st balance is divided by the appropriate life expectancy.
Two basic methods may be used to determine life expectancy when figuring subsequent year RMDs: recalculation (sometimes referred to as recomputed); or non-recalculation (sometimes referred to as once- computed or term-certain). Pursuant to Prop. Reg. Sec. 1.401(a)(9)-1, Q & A E7, financial organizations may have an establlshed policy regarding which method will be used, or they may 'allow IRA holders to choose between the two methods. If an IRA holder is allowed to choose between the two methods, he or she must make an election, in writing, no later than his or her required beginning date. As of the date of the first required distribution, this election is irrevocable (Prop. Reg. Sec. 1.401(a)(9)1, Q&A E-7(c)). If an IRA agreement allows the IRA holder to elect between the two methods, but the IRA holder does not make an election by his or her required beginning date, the recalculation method is the default option unless the IRA agreement provides otherwise.
Lock In A Life Expectancy
Non-recalculation, commonly referred to as once-computed, or as the term'certain method, allows an IRA holder to "lock in" a life expectancy in the year in which he or she attains age 70 1/2, and then simply reduce that figure by one in each subsequent year. If the IRA holder has a nonspouse bcneficiary that is greater than ten years younger, the figure derived at by non-recalculation must be compared each year with the appropriate MDIB figure.
Under the recalculation method, the IRA holder would need to refer to the unisex life expectancy tables annually. Each year the IRA holder refers to the unisex joint life expectancy tables (table VI of Reg. Sec. 1.72-9) and, using the ages which the IRA holder and his spouse will attain in the given year, looks up the appropriate joint life expectancy figure. Under this method, each year the participant lives, he or she has an additional life expectancy. The recalculation method could go up to a life expectancy of 115 years. Chart 3 illustrates the single life expectancy of a 70-year old based on a TABULAR DATA OMITTED recomputed and once-computed method.
The recalculation method will allow the participant to extend the minimum payments over a longer period of time (effectively over their entire remaining life) than the term-certain method. The recalculation method would allow the account balance to continue earning on a tax- deferred basis on a higher account balance because of a longer life expectancy. For a 70-year old starting minimum distributions at age 70 1/2, the term-certain method, on the other hand, would consume the entire IRA balance at age 86 for a single life expectancy, and age 91 for a joint life expectancy. In either method, an IRA holder can withdraw amounts greater than the minimum at any time, or even withdraw the entire account balance. If an IRA holder decides to take more than his or her required minimum, this does not mean he or she nmst continue to take out more than his or her required minimum in subsequent years. All monies withdrawn would be considered ordinary income in the year received for income tax purposes.
Chart 4 illustrates the cumulative minimum payments under the recomputed method and the once computed method. In this example, a joint life expectancy and a spouse beneficiary are being used. The account owner is age 70 and spouse is age 69. Minimum distributions commence at age 70 1/2, the starting balance of the IRA rollover is $250,000, and an 8% total annual return factor is being applied.
An IRA owner should discuss the decision whether to elect the term- certain method or the recalculation method prior to his or her required beginning date with his or her financial advisors. In addition to the financial aspects of the term-certain and recalculation methods, estate planning considerations, will need to be considered in making the selection of the proper method. There are benefits and detriments with respect to each method. In the view of most experts, a conservative approach would favor the election of the term-certain method, particularly with large balance rollovers.
The Team Approach
The proposed minimum distribution regulations are extremely detailed and cover almost 60 pages in one standard tax service. Many, perhaps most, advisors fail to recognize some of the tax savings and deferred options available for benefits from qualified plans and IRAs. Fhe failure to recognize opportunities may cost many thousands of dollars. Advisors to wealthier clients need to be able to make the clients aware of the options that exist, and to work with other advisors, (accountants, attorneys, financial planners, brokers, bank officers), to ensure tax deferral and tax savings. It is important to address personal considerations and objectives of clients, while balancing them with the tax savings and opportunities. Personal objectives, of course, come first, and tax planning should complement, not supplant, these objectives.
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