The New Retirement Distribution Rules: What They Mean To You
1 Overly complicated. That s only one of many criticisms aimed over the years at the IRS s required minimum distribution rules for taxfavored retirement arrangements. With good reason. The rules are hard to understand, even by tax-savvy individuals. But relief in the form of new, simplified rules is here. Background The tax law requires individuals who participate in employer-sponsored retirement plans and those who own traditional Individual Retirement Accounts (IRAs) to begin taking required minimum distributions (called RMDs ) from their retirement accounts when they reach age 70½. While many people start taking retirement distributions long before that age, others want to keep the money in the plan as long as possible to take advantage of continuing deferral of taxes. The purpose of the RMD rules, then, is to make sure that the money held in these tax-deferred accounts will eventually be paid out and taxed. The IRS s RMD regulations have long been considered too complex and inflexible and have often led to unfavorable decisions about taking retirement benefits that could not be altered for future years, even though the individual s financial situation changed significantly. In 2001, however, the IRS overhauled and simplified the required minimum distribution regulations. The RMD provisions, most of Copyright 2001-2003 by NPI.
2 3 which have been finalized, will benefit most, but not all, taxpayers. Moreover, they may open the door to several planning opportunities. Overview of New Regulations The new RMD rules fundamentally alter many aspects of the old rules. For example, they: Streamline and standardize the way lifetime minimum distributions are determined. Simplify post-death payouts of account balances to beneficiaries. Change the time by which a beneficiary of the account must be named. Clarify the treatment of trusts as account beneficiaries. However, the new rules also: Restrict the ability of some surviving spouses to elect to treat decedents IRAs as their own. Impose new reporting requirements on IRA trustees. In this publication, we summarize the new regulations and how they may affect your planning. It is important that affected individuals clearly understand their options. Of course, before applying any of the new rules to your situation, you ll want to obtain professional tax advice. Lifetime Minimum Distributions Under the former rules, the required minimum distribution from an IRA or a defined contribution retirement plan (such as a 401(k) or profit-sharing plan or 403(b) tax-sheltered annuity) was calculated using a method chosen by the taxpayer from among several complex formulas. The amount of the RMD depended on the life expectancy of the account owner and, in many cases, the account beneficiary. The RMD could vary significantly depending on the formula used and who was named as primary beneficiary. The new RMD rules generally provide that the lifetime required minimum distribution is to be recalculated each year based on a uniform table (see page 16). The account balance at the end of the preceding year is divided by the applicable age-based factor found in the table. The table is used whether or not the account s designated beneficiary is the account owner s spouse and with one exception discussed below regardless of the age difference between the account owner and the beneficiary. Therefore, all an account owner usually needs to determine the RMD is his or her current age and the account balance at the end of the prior year. In many cases, the use of the uniform table will result in a lower RMD than under the old rules.
4 5 Example: Rob started taking RMDs from his IRA using the joint life and last survivor life expectancy of himself and his wife, Laura. Rob had elected a formula that let him recalculate the RMD each year based on his and Laura s ages in each distribution year. In 2003, Rob reaches age 73 and Laura turns age 71. His IRA account balance at the end of 2002 was $500,000. Under the old rules, Rob s required minimum distribution for 2003 would have been $26,316. Under the new rules, the 2003 RMD is $20,243, more than $6,000 less than under the old method. The exception mentioned above: The uniform table isn t used if the account owner s spouse is the sole beneficiary of the account and he or she is more than ten years younger than the owner. In that case, a joint life expectancy table is used. This results in a lower RMD than would be computed using the new uniform table. Post-death Distributions The old RMD rules that applied after an account owner s death were as complicated and inflexible as the rules for lifetime distributions. The pitfalls were numerous, and the possibility of costly errors was great. The new regulations simplify the rules for postdeath minimum payouts. If there is a designated beneficiary for the account and the account owner dies on or after the required beginning date for the RMDs, the distribution period is, in general, the longer of the beneficiary s life expectancy or what the account owner s remaining life expectancy would have been had the owner not died. If the account owner dies before the required beginning date, the beneficiary s remaining life expectancy is the distribution period. If more than one individual is designated as a beneficiary, the distribution period is generally determined using the life expectancy of the beneficiary having the shortest life expectancy. Example: Roger is a participant in Acme Inc. s retirement plan. In 2003, Roger, age 55, dies, having designated his sister Sarah, age 48, as his sole beneficiary. Roger died before the required beginning date (see page 7). Sarah s remaining life expectancy is the minimum distribution period for his retirement benefits. If Roger had named both Sarah and Roger s older sister Kelly, age 61, as beneficiaries, then Kelly s shorter remaining life expectancy would determine the distribution period for the account. Note that, if separate accounts are created for each beneficiary, then the age of each beneficiary may be used in calculating the RMD from her separate account.
6 7 If there is no designated beneficiary and the account owner dies after the RMDs required beginning date, the account balance is paid out over the remaining table life expectancy of the owner. If there is no designated beneficiary and the account owner dies before the required beginning date of the RMDs, the account balance generally must be distributed within five years of the owner s death. If the beneficiary is an estate, the account owner is treated as having no designated beneficiary, and the above rules apply. If a charitable organization is named as a co-beneficiary of the account, the charity can be cashed out and the remaining beneficiary can take minimum distributions based on that noncharitable beneficiary s life expectancy. These new post-death distribution rules, like the lifetime rules, allow for longer payouts in some situations. Under the old rules, for instance, if an account owner began taking RMDs using a termcertain method, after the owner s death the designated beneficiary generally would have had to take the account balance over the remainder of the owner s distribution term. The new rules allow the remaining balance to be paid over the designated beneficiary s life expectancy, which, depending on the age of the beneficiary, may be much longer than the owner s remaining distribution term. Required Beginning Date The key factor in determining when required minimum distributions must start is the required beginning date. Under the tax law, minimum payments from IRAs must begin by April 1 of the year following the calendar year in which the owner reaches age 70½. (For example, an IRA owner turning 70½ in 2003 has a required beginning date of April 1, 2004.) The rules for distributions from an employer s tax-qualified retirement plan are different. For most participating employees, payments generally must start by the later of April 1 of the year following (1) the year the participant turns age 70½ or (2) the year the employee actually retires. Employees who are more than 5% owners of the employer sponsoring the plan must follow the same rule applicable to IRA owners, and a plan may provide that this rule applies to all employees. For each year after the first year, RMDs must be made by December 31. (Thus, in the example above, the RMD for 2004 must be taken by the IRA owner by December 31, 2004.) Minimum distributions may be taken any time during the year, and multiple payments are acceptable, as long as the total amount distributed equals or exceeds the required minimum amount. If an owner has multiple IRAs, for example, the aggregate RMD from the IRAs may be taken from one or any combination of the IRAs.
8 9 The new regulations do not alter these basic rules but do specify two situations in which the required beginning date may be delayed without penalty: (1) during the up-to-18-month period that a Domestic Relations Order is being reviewed by a qualified retirement plan s administrator or (2) if annuity payments are required to be made from a life insurance company that is in a state insurer delinquency program. Timing of the Beneficiary Designation Under the old RMD rules, an account beneficiary had to be designated prior to the required beginning date (or date of death, if earlier). The beneficiary generally could not be changed, for RMD calculation purposes, after that date. So, even if the beneficiary designation was changed after RMDs began because of the death of the beneficiary or due to estate-planning considerations, the original RMD calculation stayed in place for the remainder of the account owner s life, unless substitution of a new beneficiary shortened the payout period. The new regulations provide that the account s designated beneficiary for RMD purposes is generally determined as of September 30 of the year following the year of the account owner s death. (So, for an account owner who dies in 2003, the beneficiary designation need not be final until September 30, 2004.) Not only does this rule provide more flexibility, it also offers post-death estate-planning opportunities since beneficiaries may be eliminated up until the September 30 date. Note, however, that a beneficiary cannot be replaced with a beneficiary not designated as of the date of death. Postmortem Strategies In the past, many individuals with large IRA or qualified plan account balances used strategies to stretch out the time over which beneficiaries could take distributions from the account. The objective was to retain the tax-deferral benefit of keeping the money in the account as long as possible. Now, these planning methods are enhanced by the ability to delay the final designation of a beneficiary until well after the account owner s death. One strategy that should prove significant is the use of a disclaimer by a named beneficiary to pass part or all of an account to children or grandchildren. When properly implemented, this strategy may save income and/or estate taxes. Example: Charlene names her husband Jack and daughter Diane as co-beneficiaries of her 401(k) plan account. Charlene, age 50, dies in 2003. Jack doesn t need the money and legally disclaims all benefits from the account so that Diane receives the full benefit. Under the old rules, the designated beneficiaries were set at the time of Charlene s death, and a disclaimer by Jack would have no impact on the computation of the RMDs
10 11 from the account. Now, Jack s timely disclaimer before September 30, 2004, will leave Diane as the sole designated beneficiary, and the entire account may be distributed over Diane s life expectancy. Moreover, if all tax requirements are met, Jack will pay no gift or income taxes on the disclaimed money and will not have to include it as part of his taxable estate. Trusts as Beneficiaries Some individuals prefer to have their IRA or qualified plan assets transferred to a trust upon death. One reason might be to secure professional asset management for the retirement funds for the owner s family or other beneficiaries. As under the prior rules, where a trust is designated the beneficiary of the retirement account, the underlying beneficiary of the trust may be treated as the designated beneficiary for RMD purposes if all tax law requirements are met. One of the requirements is that proper documentation identifying the beneficiary(ies) of the trust be provided on a timely basis to the plan administrator or IRA trustee. Under the new regulations, the deadline for providing this documentation is, in general, October 31 of the year following the year of the account owner s death. The new rules also clarify that an underlying beneficiary of a trust created under the deceased owner s will can be treated as a designated beneficiary for RMD purposes. Example: Moe s will provides that his retirement plan assets be placed in a trust when he dies. Moe s brothers, Shemp and Curly, are the underlying beneficiaries of this testamentary trust. If Moe dies in 2003 and documentation identifying the beneficiaries (a copy of Moe s will, for instance) is provided to the plan administrator by October 31, 2004, Shemp and Curly will be treated as the designated beneficiaries of Moe s account in computing the RMDs from the account. Spousal Rollovers The new regulations clarify and, in at least one instance, restrict a surviving spouse s ability to elect to treat an IRA inherited from the deceased spouse as the survivor s own IRA. The purpose of the election is to postpone having to take required minimum distributions from the inherited IRA until the time that the surviving spouse would have to take RMDs from her/his own IRA (which may be several years later). A surviving spouse may elect to treat her/his entire interest as a beneficiary in the decedent s IRA as her/his own IRA only if the survivor is the sole beneficiary of the IRA and has an unlimited right to withdraw from the account. One way to make the election is to rename the IRA with the surviving
12 13 spouse as the owner. The election can be made any time after the IRA owner s date of death. Example: Maria dies leaving her husband, Martin, as her sole IRA beneficiary. Martin may elect to treat Maria s IRA as his own by having the IRA pay out to him any RMD payable to Maria in the year of death. The IRA trustee can rename the account in Martin s name as the owner of the IRA. One downside to the new regulations is a rule clarifying that, if a trust is named as the beneficiary of the IRA, the surviving spouse may not make the election to treat the IRA as her/his own even where the surviving spouse is named the sole beneficiary of the trust. If you are an IRA owner who has this type of arrangement in place, an immediate review of your estate plan is essential. New Reporting Requirements for IRA Trustees/Custodians In the past, IRA owners were left to their own devices to figure out the minimum required distributions they had to take. Banks, investment companies, insurers, and other IRA providers were under no obligation to provide the owner with information about the RMD amount. No more. Due to the simplified method now available for determining the required minimum distribution, the IRS will require IRA trustees and custodians either to report the amount of the RMD for the current year to the IRA owner or offer to calculate the RMD amount and provide it to the owner upon request. This reporting will be required for each IRA regardless of whether the IRA owner is planning to take the RMD from that IRA or from another IRA. The reporting requirement is effective beginning with 2003 RMDs. In addition, the IRS will have to be notified that minimum distributions are required, beginning with RMDs for 2004. Excise Tax for Failure To Take RMD The tax law provides that a 50% excise tax is payable by the account owner or beneficiary on any part of the required minimum distribution that was not taken from an IRA or qualified plan in a given year. So, if an account owner was required to take a distribution of $10,000 for a calendar year and only took $5,000, an excise tax of $2,500 (that is, 50% of the $5,000 underpayment) could be imposed. Though this penalty has been on the books a long time, the IRS has been reluctant to go after violators due to the complexity of the old rules and the lack of reporting of RMDs. With the new simplified rules and new reporting requirement, don t expect the IRS to continue its look-theother-way approach.
14 15 Nonetheless, the new regulations do contain some relief from the penalty. The IRS may waive the excise tax if the shortfall is due to reasonable error and reasonable steps are taken to correct the error. And, where an account owner dies before the required beginning date, the new rules generally allow the IRS to waive the 50% excise tax during the first five years after the year of the account owner s death if the entire benefit is distributed by the end of the fifth year following the year of death. Example: Wally dies in 2003 at age 57, leaving his retirement account to his designated beneficiary, his 80-year-old mother, June. June does not take any minimum distributions from the account. In 2008, June takes a distribution of the entire account balance. No excise tax would be imposed for June s failure to take RMDs starting with the first year after Wally s death. Effective Dates The new regulations are effective for determining RMDs for calendar years beginning on or after January 1, 2003. strategies in light of the new rules. With proper planning, significant tax savings may be possible. Moreover, individuals may be able to better plan their retirement distributions by taking advantage of the greater flexibility under the new rules. Before taking any steps, though, talk to your tax advisor. He or she will provide all the information and guidance you need to make the choices that are right for you. Planning Is the Key Individuals with retirement accounts, including IRA owners and eligible owners and beneficiaries of qualified retirement plans, should take the opportunity to review their current distribution This summary involves sophisticated tax-planning concepts. Before applying anything in it to your personal or business situation, you should contact a professional advisor. The general tax information in this publication may or may not be appropriate to you, and a professional will be able to advise you in the context of your specific circumstances.
16 Uniform RMD Table The following table is used for determining the period for lifetime distributions based on the age of the account owner. An exception to the use of this table applies where the owner s spouse is the designated beneficiary and the spouse is more than ten years younger than the owner. Age Distribution Period 70 27.4 71 26.5 72 25.6 73 24.7 74 23.8 75 22.9 76 22.0 77 21.2 78 20.3 79 19.5 80 18.7 81 17.9 82 17.1 83 16.3 84 15.5 85 14.8 86 14.1 87 13.4 88 12.7 89 12.0 90 11.4 91 10.8 92 10.2 Age Source: IRS Regulation Sec. 1.401(a)(9)-9, A-2. Distribution Period 93 9.6 94 9.1 95 8.6 96 8.1 97 7.6 98 7.1 99 6.7 100 6.3 101 5.9 102 5.5 103 5.2 104 4.9 105 4.5 106 4.2 107 3.9 108 3.7 109 3.4 110 3.1 111 2.9 112 2.6 113 2.4 114 2.1 115 and 1.9 older FX2003-0303-0098 RDR 2/03