Distribution Rules for Retirement Funds

            Those of us who are not quick in hand-eye coordination games, such as badminton, would probably not play video-computer games either. That doesn’t mean we can’t watch our children and grandchildren play video games.  In watching these games being played by others, I have observed one common element:  the protagonist always has a number of choices as to where he will travel, be it Tunnel Number 1, Tunnel Number 2, and so forth.  Once the hero has entered the tunnel of his choice, he is confronted with new terrain, new enemies, and will have to use existing as well as new weapons.

            The new distribution rules for retirement funds are analogous to video games: the protagonist will be entering different “tunnels”, each with a different set of rules.  These rules are much different from the old set of rules, and even if withdrawals from retirement funds were made before January 1^st of 2003, using the old rules, the protagonist will be using the new rules.  To quote Michelangelo of the Teenage Mutant Ninja Turtles, “Dude, the old rules are toast.”

            First, some housekeeping matters. The rules apply to distributions from individual retirement accounts (IRAs), qualified retirement plans, deferred compensation plans under Section 457, and Section 403(b) annuity contracts.

Second, the regulations help IRA owners and qualified retirement plan participants (and the beneficiaries of both groups) to reduce income taxes, by reducing the annual distributions. To achieve this noble objective, new life expectancy tables have been published. 

Third, this article will use a computer-game technique, when different concepts are explained.  The concepts will be labeled “tunnels”.  Once you enter a given tunnel, e.g., Tunnel 1, you cannot escape, unless the tunnel gives you permission to jump to another tunnel.

Fourth, there are some rules to be followed to play this computer game.  Just as Monopoly, Clue, and Chutes and Ladders have rules, the Treasury Department has its own set of rules. 

Fifth, this article does not cover all of the rules. My purpose is to give a rather long, thumbnail sketch of the new Treasury regulations. 

The Rules

Required beginning date.  An individual must begin receiving distributions from his IRA or qualified retirement plan no later than his required beginning date (“RBD”). What, then, is the required beginning date?

The required beginning date is generally April 1 of the year following the calendar year in which the IRA owner attains age 70-1/2. (In the case of qualified retirement plans but not IRAs, the required beginning date is the later of April 1 of the year following the calendar year in which the plan participant attains age 70-1/2 or April 1 of the year following the calendar year in which the participant retires, unless the participant is a 5% or more owner of the business sponsoring the qualified retirement plan, in which case the April 1^st following the age 70-1/2 date applies.)

The Table: How much must be withdrawn?  Almost all IRA owners may use one uniform table to calculate their required minimum distributions, by dividing their IRA December 31^st account balance (of the prior year) by the relevant factor taken from the uniform table, shown as Exhibit 1. The factor to use is based on the IRA owner's age at his or her birthday in the year for which the required minimum distribution is being determined. The uniform table reflects longer, current life expectancies, which means, slightly smaller annual required minimum distributions. These tables relate to required minimum distributions (after a person reaches age 59 1/2, IRA withdrawals may be made without income tax penalties; this articles does not cover that situation: we are discussing situations where a person doesn't want to withdraw from his or her IRA, until he or she is forced to withdraw).

Example. George reached age 73 on 8/5/03. His IRA was valued at $1,000,000 on 12/31/02. He finds his age on the table (Exhibit 1), and determines the factor to be 24.7.  He divides this number into $1,000,000, and determines the required minimum distribution to be $40,485.

Is the Table our only choice?  Except for surviving spouses who are ten years younger than the IRA owner, there is only one table to use.  In such an instance, the actual joint and survivor life expectancy of the owner and the owner's spouse is used to determine their required minimum distributions.  Let’s cover this situation by an example.  Bob and his wife, Darlene, are, respectively, 74 years old and 60 years old in 2002. Darlene is the sole beneficiary of Bob's IRA. Bob's IRA was valued at $1,000,000 as of 12/31/01. Under the revised joint and survivor life expectancy table (which is not reproduced in this article), Bob's 2002 required minimum distribution is $37,594, determined by dividing his $1,000,000 account value on 12/31/01 by the 26.6-year joint life expectancy of a 74 year old and a 60 year old. If Darlene were not Bob's sole beneficiary or if Darlene were not Bob's wife and Bob elected to use the new rules for 2002, his 2002 required minimum distribution would be $42,017 ($1,000,000 ÷ 23.8) because 23.8 is the applicable factor for a 74 year old under the revised uniform table.

When is marital status determined? The account owner's marital status is determined on January 1 of the calendar year. If the account owner is married on January 1, he will be considered as married for the entire calendar year, even if the account owner and/or his spouse die during the year or they divorce during the year. In addition, if an IRA owner changes his beneficiary designation as a result of the death of his spouse or his divorce, the change will not be recognized for minimum distribution purposes until the year after the spouse's death or the year after the divorce.

            Who is a designated beneficiary?  To play this computer game, i.e., to be permitted to enter one of the tunnels described below, you must be a designated beneficiary, which is to say, someone other than a mere beneficiary.  A designated beneficiary is an individual who has a life expectancy.  A charity or an estate is not a designated beneficiary.  You’ll understand the difference between a designated beneficiary and a mere beneficiary, as this article unfolds.

What gets reported? IRA custodians must notify IRA owners when a required minimum distribution is due and advise them that the custodian will compute the amount of the required minimum distribution for the owner upon request. The new rules do not require IRA custodians to notify IRA beneficiaries that a required minimum distribution is due.  Beginning in 2004, however, IRA custodians must report to the IRS when a minimum distribution is due with respect to an IRA; however, the IRA custodians are not required to report the amount of the required minimum distribution.

Tunnel Number 1: Spouse as beneficiary

If the designated beneficiary is the spouse of the IRA owner, there are several options available:

First, the surviving spouse may roll over the IRA into his or her IRA.  This is not a taxable event, since no money has been withdrawn.  Distributions will not begin until the surviving spouse’s required beginning date.

Second, if an IRA owner dies before his required beginning date, and has named his spouse as his sole beneficiary, distributions need not commence until the later of (1) the end of the calendar year immediately following the calendar year in which the IRA owner died or (2) the end of the calendar year in which the deceased IRA owner would have attained age 70-1/2.

Example. Bud dies in April 2002 at age 66-1/2; he named his wife, Mary, as the sole beneficiary of his IRA. Mary was born on November 2, 1938, and was 63 at the time of Bud's death. Because Bud died prior to his required beginning date, Mary is not required to begin receiving distributions from Bud's IRA until the later of December 2003 (the calendar year after the year of Bud's death) or December 2006 (the calendar year in which Bud would have attained age 70-1/2). Mary may alternatively roll over the IRA to an IRA in Mary's name or elect to treat the IRA as her own. If Mary elects either of these options, distributions need not commence until Mary's required beginning date, April 1, 2010 (the calendar year after the year when Mary attained age 70-1/2).

Third, If the IRA owner dies on or after reaching his required beginning date, and had named his spouse as his sole beneficiary, the surviving spouse must (1) commence receiving distributions no later than the end of the calendar year immediately following the calendar year in which the IRA owner died, (2) roll over the IRA to an IRA in the surviving spouse's name, or (3) elect to treat the IRA as the spouse's own in the same manner as described above.

Should the surviving spouse elect to receive distributions over her life expectancy, her distribution period will initially be calculated based on the spouse's age at her birthday in the year following the year of the IRA owner's death. The spouse's life expectancy will then be recalculated in each subsequent year in which the spouse is alive. If the IRA has not been fully distributed to the spouse by the time of her death, distributions may continue to be made to her successor beneficiary (named either by the IRA owner or by the spouse) for the years after the death of the surviving spouse. The distribution period with respect to the successor beneficiary will be equal to the surviving spouse's life expectancy, determined at the surviving spouse's birthday in the year of her death and reduced by one for each subsequent year.

If a surviving spouse elects to treat the IRA as her own IRA, the required distribution must have been paid to the deceased IRA owner or must be paid to the surviving spouse as beneficiary. The required minimum distribution is calculated as if the IRA owner had lived throughout the entire calendar year in which his death occurred. Furthermore, if the surviving spouse is himself or herself beyond his or her required beginning date, then, beginning with the year immediately following the year of the IRA owner's death, a distribution must be made to the surviving spouse with respect to the deceased spouse's IRA. This distribution is calculated under the uniform table applicable to the surviving spouse as owner and not under the single life expectancy table applicable to the spouse as beneficiary.

Example. Harry, age 75, dies in July 2002.  He had named his wife, Beverly, age 74, as the sole beneficiary of his IRA. In September 2002, Beverly elects to treat Harry's IRA as her own by retitling it in her own name. In order for Beverly to treat Harry's IRA as her own, Harry's required minimum distribution for 2002, determined by dividing the account value on December 31, 2001, by the 22.9-year uniform table factor applicable to Harry in 2002, must either have been distributed to Harry before he died or if it was not so distributed, be distributed to Beverly by December 31, 2002. Because Beverly is herself past her required beginning date, Beverly must commence receiving minimum distributions in 2003 from the retitled IRA, using the uniform table factor applicable to Beverly as the owner of the IRA.

Tunnel Number 2:  Distributions After Death (but before RBD)

What happens when the owner of an IRA dies before reaching the required beginning date for distributions?  Under the new rules, a beneficiary of a deceased IRA owner generally receives distributions over his or her life expectancy. The beneficiary's life expectancy is determined using the age of the beneficiary at his or her birthday in the year following the year of the IRA owner's death. For a beneficiary who is not the IRA owner's surviving spouse, such life expectancy is then reduced by one for each subsequent year. This beneficiary life expectancy rule applies, however, only to "designated beneficiaries," i.e., beneficiaries who are individuals, as opposed to entities such as an estate or a charity.

Example. Linda is Karen’s designated IRA beneficiary.  Karen dies in 2001, and as of December 31, 2001, the IRA is worth $500,000; Linda is 36 years old. Under the life expectancy rule, Linda may receive distributions over her life expectancy, based on Linda's age, providing the distributions begin before December 31, 2002.  Linda's life expectancy in 2002 is 46.5 years (the single life expectancy factor applicable to a 37 year old under the revised single life expectancy table). Linda's 2002 required minimum distribution is therefore $10,753 ($500,000 ÷ 46.5). If Karen's IRA is valued at $495,000 on December 31, 2002, Linda's 2003 required minimum distribution will be $10,879 ($495,000 ÷ 45.5).

Suppose Linda doesn’t like this arrangement. She is permitted to receive the IRA, providing it is completely distributed by the end of the calendar year that contains the fifth anniversary of the IRA owner's date of death.  Since Karen died in 2001, the entire IRA must be distributed no later than December 31, 2006.

Tunnel Number 3:  The Date When the Designated Beneficiary is Determined

            Under the new rules, the designated beneficiary is determined on September 30 of the year following the year of the IRA owner's death. This means a nonspouse beneficiary will have three months to make arrangements to receive his or her initial required minimum distribution, which must be received no later than December 31 of the year following the year of the IRA owner's death.

What if the designated beneficiary dies before receiving distributions? The remaining life expectancy of the deceased beneficiary is used for minimum distribution purposes, even if the IRA is payable to a successor beneficiary as a result of the primary beneficiary's death. The IRA would is payable to a successor beneficiary named either by the IRA owner or the primary (now deceased) beneficiary or, if no successor beneficiary is so named, as provided in the IRA custodian agreement or by state law (generally, to the deceased beneficiary's estate).

Example. Jim died on December 1, 2001, survived by his daughter, Colleen, and his grandson, Holden. Colleen was the designated beneficiary of his IRA; Jim named no contingent beneficiary. After Jim's death, Colleen named Holden as the successor beneficiary of Jim's IRA. Colleen died on June 1, 2002, without disclaiming her interest in the IRA. Colleen will be considered Jim's designated beneficiary notwithstanding her death prior to September 30, 2002 (the date on which Jim's designated beneficiary is determined). As a result of Colleen's naming Holden as the successor beneficiary, the IRA will be payable to Holden over Colleen's life expectancy, based on Colleen's age at her birthday in 2002 and reduced by one for each subsequent year. The result would be the same if Jim's beneficiary designation provided that Holden would be the successor beneficiary, had Colleen died prior to receiving Jim's IRA.

Tunnel Number 4:  Multiple Beneficiaries

If an IRA owner designates multiple beneficiaries, the post-death distribution period is determined by the designated beneficiary whose life expectancy is shortest. Thus, if Bart designated his three children, Greg, Tom, and Judy, as the beneficiaries of his IRA, the distribution period for all three children after Bart's death is based on the life expectancy of the oldest child.

Suppose that Bart had designated his three children and a charity as his beneficiaries. In this case, following Bart's death, the three children would not be able to use any of their life expectancies as the distribution period, because a charity does not qualify as a “designated beneficiary”.  In this instance, the IRA will be paid in a lump sum to each of the four beneficiaries, which means, the beneficiaries will be paying a bit more in income tax (they won’t be able to amortize the IRA over the shortest life expectancy).

Fortunately, the new rules permit some postmortem estate planning measures. The charity must have its interest paid out in full on or before September 30 of the year following the year of the IRA owner's death.  If that action is taken, the charity’s status is not taken into account in determining the designated beneficiary for minimum distribution purposes. Similarly, if the charity disclaims its interest in the IRA prior to that same September 30 and the disclaimer meets the requirements of IRC Section 2518, then the charity is also not taken into account for purposes of determining the designated beneficiary.

As an alternative (which Bart ought to do when he designates the beneficiaries), the plan administrator might create separate accounts for each of the multiple beneficiaries, and each beneficiary would determine his or her required minimum distribution based on his or her individual life expectancy, as opposed to using the life expectancy of the beneficiary whose life expectancy is shortest. The separate accounts will be recognized for required minimum distribution purposes after the later of (a) the year of the IRA owner's death or (b) the year in which the separate accounts are established (but before September 30^th of that year).

If separate accounts are established, separate accounting for such accounts will allocate all post-death investment gains or losses for the period prior to the establishing of the separate accounts on a pro rata basis, in a reasonable and consistent manner among the separate accounts for the different beneficiaries. The separate accounts must also allocate any post-death distributions to the separate accounts of the beneficiaries receiving such distributions.

Tunnel Number 5:  Death After Required Beginning Date

Suppose the IRA owner has reached the required beginning date (RBD) for mandatory distributions, and then dies.  If the account owner designates his or her estate as the beneficiary the post-death distribution period is the IRA owner’s life expectancy calculated in the year of death and reduced by one for each subsequent year.

Suppose the IRA owner dies after the RBD, but designates a beneficiary who is older than the deceased IRA owner. Under the new rules, the designated beneficiary’s distribution period is the longer of (1) the life expectancy of the beneficiary (determined in the year after the year of the IRA owner’s death) or (2) the remaining life expectancy of the IRA owner (determined at his or her birthday in the year of death and reduced by one for each subsequent year).  As a result of this change, the older beneficiary’s required minimum distributions will be smaller.

Tunnel Number 6:  Trust as beneficiary

If a trust is named as the beneficiary of an IRA, one might conclude that the trust is a mere beneficiary, not a designated beneficiary, and that the plan administrator will be compelled to make a lump sum distribution to the trustee (which will result in more income taxes).  Fortunately, the rules give a bit more flexibility. 

First, the trust must meet certain standards, i.e., the trust must be a valid trust under state law, the trust must be irrevocable or become irrevocable upon the account owner's death, the beneficiaries of the trust must be identifiable, and certain documentation requirements must be satisfied (which are, a copy of the trust or a certified list of the trust beneficiaries must be provided to the IRA administrator, trustee, custodian, or issuer).  If the trust meets these criteria by October 31 of the year following the year of the IRA owner's death, then the trust will be regarded as a conduit, and the designated beneficiaries will be the beneficiaries of the trust, and the other rules (“tunnels”) can be used, to determine the amount to be distribute to the beneficiaries.

Summary

The new regulations generally increase the ability of IRA owners and qualified retirement plan participants (and the beneficiaries of both groups) to reduce their income taxes by reducing the amounts of their required minimum distributions. The rules permit all taxpayers to calculate their required minimum distributions under the revised, longer life expectancy tables and to simplify calculations.

Exhibit 1.Uniform Table

Age of the       Distribution         Age of the           Distribution

Employee         Period               Employee             Period

70               27.4                 93                   9.6

71               26.5                 94                   9.1

72               25.6                 95                   8.6

73               24.7                 96                   8.1

74               23.8                 97                   7.6

75               22.9                 98                   7.1

76               22.0                 99                   6.7

77               21.2                 100                  6.3

78               20.3                 101                  5.9

79               19.5                 102                  5.5

80               18.7                 103                  5.2

81               17.9                 104                  4.9

82               17.1                 105                  4.5

83               16.3                 106                  4.2

84               15.5                 107                  3.9

85               14.8                 108                  3.7

86               14.1                 109                  3.4

87               13.4                 110                  3.1

88               12.7                 111                  2.9

89               12.0                 112                  2.6

90               11.4                 113                  2.4

91               10.8                 114                  2.1

92               10.2                 115 and older  1.9

Pension Protection Act of 2006 Post Script

 

            This post script doesn’t deal with the Minimum Distribution Rules. However, the Pension Protection Act opened one door which is not available to traditional and Roth IRAs: if a parent dies leaving some untapped 401(k) money to a child (or any other non spouse beneficiary), the child can roll these funds into the child’s own IRA. Thus, if the child (or other non spouse beneficiary) is wise, the child will simply rollover whatever was left in mom or dad’s 401(k) plan (or 403(b) or 457 plan), into his or her IRA. At that point, the Minimum Distribution Rules will apply to the child (and the child might consider the non-penalty withdrawal options available under Section 72(t) of the Internal Revenue Code).

 

            In addition, the plan participant can rollover his or her benefits to a tax sheltered annuity, or to another qualified retirement plan.

 

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

 

            Although IRAs are protected during bankruptcy proceedings to the extent of $1,000,000, there are no dollar limitations for funds held in a qualified retirement plan (401(k), profit sharing, money purchase, ESOPs, defined benefit, 403(b) plans, and 457(b) plans of state and local governments). If a plan participant rolls over his or her benefit to an IRA, tax sheltered annuity, or another qualified retirement plan, those benefits are protected from creditors claims, in a bankruptcy proceeding, so long as the amounts rolled over are not commingled with other traditional and Roth IRAs.