Background

The tax law requires IRA owners and pension plan participants to begin taking distributions from their retirement funds when an individual reaches a certain point - known as the required beginning date (RBD). Once you reach this date, which is normally April 1 of the year after you turn age 70½, you’re always free to take more (subject to whatever your particular pension plan or IRA may allow), but the tax rules require that you take at least a certain amount.

The required amount, known as the minimum required distribution (MRD), is calculated annually and must be distributed no less frequently than once a year. Failure to take the distribution required for a year results in a penalty of 50% of the excess of the MRD for that year over the amount actually taken as a distribution [IRC Sec. 4974(a)].

For many years, taxpayers and their advisors looked to a set of proposed regulations issued in 1987 for guidance on how to interpret MRD rules. These proposed regulations were replaced with a second set of much improved proposed regulations issued early last year. Now the IRS has finalized the January 2001 regulations and generally kept the same simplified rules, with a few important modifications, as discussed below. (Note: This article focuses on the new rules as they relate to IRAs - although the requirements for other retirement plans are generally the same.)

Effective Date: The new regulations apply for the purpose of determining MRDs for calendar years beginning after 2002. For the purpose of determining this year’s MRDs, the IRS says taxpayers have a choice. They may rely on the new final regulations, the 2001 proposed regulations, or the 1987 proposed regulations.

Observation: Taxpayers will nearly always be better off (meaning they’ll have a lower required distribution), if they use the final regulations to calculate this year’s MRD. One exception to this applies to beneficiaries of taxpayers who (1) died after their required beginning date and (2) were calculating their MRDs prior to death using the old term certain method (under the 1987 proposed regulations) over the joint life expectancy of themselves and their beneficiary. In this situation, the beneficiary will be required to take a smaller MRD this year by following the 1987 proposed regulations than if the 2002 regulations are followed. (Next year, the beneficiary will need to follow the new regulations to calculate 2003’s MRD.)

New (and Improved) Life Expectancy Table    Back to Top

The biggest change made by the final regulations is to update the Life Expectancy Table included in the 2001 regulations to reflect current (improved) life expectancies. The new table (included as Appendix 1) is used to calculate the MRD distribution period for all IRA owners, other than in situations where the only primary beneficiary of an IRA owner’s account is his or her spouse and that spouse is more than 10 years younger than the IRA owner. If the participant’s spouse is both the sole beneficiary and more than 10 years younger, a longer distribution period measured by the joint life expectancy of the participant and spouse may be used. [see the new Joint and Last Survivor Table in Reg. 1.401(a)(9)-9, Q/A-3]. These tables provide for distributions to occur over a longer period than the previous tables in either the 2001 or 1987 regulations. Thus, they’ll result in lower required minimum distributions except in certain limited situations, such as the one described in the previous paragraph.

Example 1: A taxpayer is already taking minimum distributions.    Back to Top

Paul turns 77 this year and his wife, Ernestine, who is the beneficiary of all of his IRAs, will be 75. At the end of 2001, his traditional IRA balances totaled $500,000. Under the 1987 proposed regulations (Table VI of Reg. 1.72-9), this means his MRD for this year is $31,646 ($500,000 ÷ 15.8), assuming he elected to recalculate his and his wife’s life expectancies each year.

Under the 2001 proposed regulations, Paul is required to take out $24,876 ($500,000 ÷ 20.1) in 2002. However, should he choose to use the 2002 final regulations to calculate this year’s MRD (and there’s no reason not to if he wants to take out the smallest amount possible), his MRD for this year is only $23,585 ($500,000 ¸ 21.2). That’s a 5% decrease from what the 2001 regulations require and a whopping 25% decrease from what the 1987 regulations require. Of course, regardless of the regulations he chooses to follow, Paul is always free to take more than the minimum amount without penalty because he is over age 59½.

Example 2: Life expectancies are redetermined every year.    Back to Top

Assume the same facts as in Example 1, except that it is 2003 and Paul’s traditional IRA balances total $495,000 at the end of 2002. To calculate his MRD for 2003, Paul must use the table included in the 2002 final regulations (and in Appendix 1 of this article). Because he will be 78 on his birthday in 2003, Paul’s MRD for 2003 is $24,385 ($495,000 ¸ 20.3).

Example 3: Roth IRAs.    Back to Top

Assume the same facts as in Example 1, except that all of Paul’s IRAs are Roth IRAs. Here, his MRD for 2002 is zero, regardless of which set of regulations he follows. The MRD rules don’t apply to Roth IRAs during the account owner’s lifetime [IRC Sec. 408A(c)(5)]. If Ernestine survives Paul and elects to treat all of his Roth IRAs as her own, the MRD rules also will not apply during her lifetime.

Determining an Account’s Designated Beneficiary    Back to Top

For tax purposes, it’s generally unnecessary under either the 2001 or 2002 regulations to identify an IRA owner’s beneficiary as long as the owner is alive (because the same life expectancy table is used in every situation but where the beneficiary is a spouse who is more than 10 years younger than the owner). However, the rules change at the time of the account owner’s death.

For the purpose of calculating MRDs after the account owner’s death, a beneficiary can be eliminated after the owner’s death, but no new beneficiaries can be added (see Example 4 later in this article). Thus, for example, having rights to the IRA under the decedent’s will or applicable state law does not make that individual a designated beneficiary for purposes of determining the MRDs. Likewise, when an individual is a sole beneficiary of an estate that is named as the designated beneficiary of the IRA, the estate cannot be "looked through" to consider the individual as the designated beneficiary.

Caution: It is critical that account owners name appropriate beneficiaries for their IRAs prior to their death. When the 2001 regulations were released, there was some confusion about whether a beneficiary could be added after an owner’s death. However, the 2002 regulations make it clear that to be considered for MRD purposes, the beneficiary must be a beneficiary at the time of the owner’s death.

Under the 2002 regulations, the final determination of the beneficiary(ies) of an IRA becomes fixed on September 30 of the year following the participant’s death [Reg. 1.401(a)(9)-4, Q&A 4]. (The 2001 regulations provided a cut-off date of December 31 of that same year.) By moving up the determination date by three months, beneficiaries will have more time for the MRD to be calculated and distributed before the end of the year following the year of the participant’s death (i.e., the date that MRDs to nonspouse beneficiaries must begin).

Observation: Because a person’s status as a beneficiary isn’t set until the year after the taxpayer’s death, several postmortem planning opportunities may be available. For example, one or more beneficiaries could disclaim their interest (such as a son making a valid disclaimer under IRC Sec. 2518 of an interest in the IRA so that it flows to his kids). This rule also allows time for distributions to be made to buy out certain beneficiaries (such as a charity) so that the remaining beneficiaries can stretch out their IRA distributions over a longer period than what is allowed when an IRA has a beneficiary that’s not an individual [Reg. 1.401(a)(9)-4, Q/A-3 and Q/A-4]. And finally, if a taxpayer leaves behind an IRA with multiple beneficiaries, those beneficiaries can use this rule to either split the IRA into multiple IRAs with a single beneficiary for each or leave the IRA intact but create separate shares for each beneficiary. Choosing either option will allow each beneficiary to take distributions using his or her own life expectancy. If they do nothing, they’ll all have to take distributions from the IRA based on the life expectancy of the oldest beneficiary [Regs. 1.401(a)(9)-5, Q/A-7; 1.401(a)(9)-8,Q/A-2(a)(2) and Q/A-3].

Example 4: Removing a disqualified beneficiary.    Back to Top

Tyler, who turned 75 in 2002, has one traditional IRA. The IRA’s balance at the end of last year was $600,000 and his beneficiaries for the account are his younger brother (Travis) and sister (Tara) and his church, in equal shares. At his death on October 15, 2002, Tyler had not taken his MRD for 2002.

Assuming Travis (who is 72 in 2002) and Tara (who is 65) want to stretch out the distributions from Tyler’s IRA over as many years as possible, what should they do?

Only individuals (and certain trusts) can be a qualified beneficiary for MRD purposes. If any nonindividuals are designated as an IRA’s beneficiaries, the IRA is treated as not having a designated beneficiary for MRD purposes, even if there are also individuals designated as beneficiaries [Reg. 1.401(a)(9)-4, Q/A-3]. Thus, if Tyler’s church remains a beneficiary, Travis and Tara will be forced to take distributions using Tyler’s remaining life expectancy (i.e., his life expectancy based on his age on his birthday in the year he died, reduced in subsequent years by one for each calendar year that has elapsed since the year of his death) [Reg. 1.401(a)(9)-5, Q/A-5(a)(2) and (c)(3)]. Alternatively, if before September 30, 2003, the church’s share of the IRA is distributed, and Travis’s and Tara’s shares of the IRA are split into separate shares or into separate IRAs, Travis and Tara may each take distributions based on their own life expectancies.

Post Death Distributions    Back to Top

Example 5: IRA owner with a named beneficiary.    Back to Top

The balance of Kayla’s traditional IRAs on 12/31/01 was $600,000 and the beneficiary of all of the IRAs is her son Nick. Kayla dies in 2002, shortly after turning age 73 and before she has had a chance to take her required distribution for the year. Nick turns 46 in 2002.

Kayla’s 2002 minimum distribution (which will obviously be paid after her death) is calculated using the table in Appendix 1 and using her age as of her birthday in 2002 [Reg. 1.401(a)(9)-5, Q/A-4(a)]. Thus, $24,292 ($600,000 ÷ 24.7) must be distributed to Nick in 2002. In 2003 and later years, minimum distributions are measured by the beneficiary’s (Nick’s) remaining life expectancy as determined using Nick’s age (47) on his birthday in the calendar year following Kayla’s death [Reg. 1.401(a)(9)-5, Q/A-5(a)(1)(i) and (c)(1)]. Nick’s life expectancy is determined from the Single Life Table (see Appendix 2). Thus, if the balances of Kayla’s IRAs on 12/31/02 total $635,000, the minimum required distribution that Nick must take in 2003 is $17,162 ($635,000 ÷ 37). In later years, the divisor will be reduced by one each year. As a result, the IRAs’ balances at 12/31/03 will be divided by 36 to determine how much Nick must take in 2004.

Variation: Suppose Kayla had been 69 at the time of her death. Here, no MRD would be required in 2002. However, Nick would still have to take his first MRD in 2003 (calculated as shown above), unless he (or Kayla, before her death) elected for him to receive (or the IRA trust documents required him to receive) distributions under the five-year rule. If the five-year rule applies, the entire balance in the IRA must be distributed to Nick by no later than 12/31/07 (i.e., by the end of the fifth calendar year after the year the account owner died). Under the five-year rule, the distributions can be in a single lump sum or in several equal or unequal payments during the five year period.

Example 6: Owner dies before birthday in year of death.    Back to Top

Assume the same facts as in the main part of Example 5, except that Kayla dies in 2002 prior to reaching her 73rd birthday. Here the results are the same as in Example 5. It doesn’t matter whether Kayla dies before, on, or after reaching her birthday in the year of death. If she has already reached her required beginning date, the distribution for the year of death is based on the account owner’s age (or the age he or she would have reached) on their birthday in the year of death.

Example 7: IRA owner with older beneficiary.    Back to Top

Assume the same facts as in Example 5, except that Nick turns 86 in 2002 and is Kayla’s brother. The general rule is that beginning with the year after Kayla’s death, the IRA balance must be distributed over Nick’s life expectancy. However, because Nick is older than Kayla, he has the option of taking the distributions over Kayla’s life expectancy using her age as of her birthday in the year of her death and reducing that life expectancy by one for each subsequent year.

Using the Single Life Table (Appendix 2) and Kayla’s age of 73 in 2002 yields a divisor of 14.8. Thus, if the balance of Kayla’s IRAs is $635,000 on 12/31/02, the amount Nick must take as a distribution in 2003 is $46,015 [$635,000 ¸ (14.8 – 1)]. In contrast, if Nick based the MRDs on his own life expectancy, the required distribution in 2003 would be $94,777 ($635,000 ¸ 6.7) based on the Single Life Table and Nick’s age of 87 in the year after Kayla’s death.

Example 8: IRA owner dies without a designated beneficiary.    Back to Top

Mark dies in 2002, shortly after his 74th birthday and before taking his MRD for the year. His estate is named the beneficiary of his traditional IRA (that had a balance of $200,000 at the end of 2001). Because an estate is not a qualified beneficiary, his IRA is treated as not having a designated beneficiary. Thus, the balance in Mark’s IRA must be distributed over his life expectancy using his age on his birthday in the year of death (and reducing the life expectancy by one in each subsequent year).

Mark’s 2002 minimum distribution (which will obviously be paid after his death) is calculated using the table in Appendix 1 and using his age as of his birthday in 2002 [Reg. 1.401(a)(9)-5, Q/A-4(a)]. Thus, before the end of 2002, $8,404 ($200,000 ¸ 23.8 from Appendix 1) must be distributed to his estate. Then, assuming the IRA balance at the end of 2002 is $210,000, a total of $16,031 ($210,000 ¸ 13.1, which is 14.1 – 1 from Appendix 2 because it is the year after death) must be distributed to his estate
during 2003.

Special Rules for Surviving Spouses    Back to Top

Consistent with the 2001 regulations, the 2002 final regulations say a surviving spouse (let’s assume it’s the wife) may elect to treat the decedent’s IRA as her own (by redesignating the account in her name), but only if she is the sole beneficiary of the IRA and has an unlimited right to take withdrawals from the account. As under the 2001 regulations, the 2002 regulations provide that these rules aren’t met if a trust is named as the designated beneficiary, even if the wife is the sole beneficiary of the trust [Reg. 1.408-8, Q/A-5(a)].

A surviving spouse, who is the sole beneficiary (with unlimited withdrawal rights), is deemed to have made the election to treat the IRA as her own if any amount, that’s required to be distributed to her as the beneficiary (rather than as the owner) of the IRA, is not distributed on time or if she contributes additional amounts to the IRA (Reg. 1.408-8, Q/A-5).

If a surviving spouse elects (or is deemed to elect) to treat the decedent’s IRA as her own, the MRD for the calendar year of the election and each year thereafter is determined by treating the surviving spouse as the owner, rather than the beneficiary of the IRA. Thus, the election can be beneficial if the surviving spouse is younger than the decedent and currently doesn’t need the IRA funds. However, the election can be a trap if the surviving spouse is not yet age 59½ and may need to take IRA withdrawals prior to that age [since the IRC Sec. 72(t)(2)(A)(ii) exception to the 10% early withdrawal penalty would apply to the surviving spouse as a beneficiary but not as owner of the decedent’s IRA]. One way around this trap is simply to wait until after the surviving spouse reaches age 59½ before electing to treat the decedent’s IRA as her own (and taking any required MRDs as a beneficiary prior to that date) [Reg. 1.408-8, Q/A-5(a)].

If a surviving spouse elects to treat the decedent’s IRA as her own in the year the IRA owner dies, the MRD, if any, for that year is determined as if the decedent survived for the entire year. Thus, if the decedent was required to take an MRD in the year of death but didn’t, the surviving spouse must take it in the decedent’s place [Reg. 1.408-8, Q/A-5(a)].

If a surviving spouse chooses to remain the beneficiary of the decedent’s IRA (rather than to make it her own), MRDs to the surviving spouse must begin by the later of December 31 of the year after the decedent’s death or December 31 of the year in which the account owner would have reached age 70½ [Reg. 1.401(a)(9)-3, Q/A-3(b)].

More To Come

Although we’ve covered what we believe are the most significant points in the new final regulations, at over 100 pages long, there are several more issues in the regulations worth discussing (such as the rules on trusts, the impact of post year-end contributions or withdrawals, and IRA trustee reporting requirements). These will be addressed in a follow-up article within in the next few issues. Meanwhile, a sample client letter is included with this article to use in alerting your clients to the changed rules that could impact any MRDs they might take this year.

As a subscriber to this newsletter, you can edit and distribute the sample letter to clients, potential clients, and referral sources as you see fit.

Appendix 1
Applicable Divisors for Determining Minimum Distributions¹    Back to Top

Appendix 2
Single Life Table²    Back to Top