How Do The New IRA Rules Affect You?

The pre-2001 rules for IRA distributions were based on regulations first proposed in 1987, which produced a complex system with a virtually infinite number of possible combinations when it comes to distributions. Unfortunately, this complexity has led to confusion and uncertainty, and worst of all, lack of compliance. When a system becomes overly complicated, the potential becomes great for certified public accountants (CPAs) and account owners to err in calculating distributions. The IRS is aware of this, and thanks to the new rules, you can look forward to simplified distribution rules. The new rules will be optional for 2001 and mandatory for 2002. What do these new rules mean for you?

IMPORTANT CHANGES

Under the pre-2001 rules, the minimum distribution requirement varied with your age as well as the age of your designated beneficiary. The new 2001 rules propose a simple uniform life expectancy table to be used for all IRA owners, regardless of the age of your designated beneficiary. The only exception is if your spouse is more than 10 years younger than you, in which case a different life expectancy table must be used.

With these new rules, you no longer have to decide whether to recalculate life expectancy annually. This was necessary under the 1987 proposed regulation method, where the potential for recalculating or not for both you and your designated beneficiary created four different options. Even with sophisticated software, it is difficult to rationally compare the benefits and detriments of these options. The new single table proposed in the 2001 rules allows the account owner to calculate the minimum distribution.

It is now possible to change your beneficiary at any time. Under the pre-2001 rules, changing a beneficiary can lead to larger distributions. Even if the beneficiary has a longer life expectancy, the new rules will not result in smaller distributions. On the other hand, the new system will allow complete freedom to select designated beneficiaries and have no impact on the required minimum distribution. A new beneficiary must be selected by the end of the year following the death of the owner. This provision allows for disclaimers and cashing out some beneficiaries and also provides the opportunity to stretch out the inherited IRA by several years.

The distributions at death will generally be permitted over the remaining life expectancy of the owner or the life expectancy of a designated beneficiary, whichever period of time is greater. This new method will generally reduce required distributions for the majority of IRA owners and beneficiaries, although you can withdraw an amount greater than the minimum.

HOW DOES IT WORK?

The minimum distribution table (MDIB) displayed in Figure 1 shows the life expectancy of both you and your theoretical designated beneficiary, who is no more than 10 years younger than you in this example. It displays the largest life expectancy or denominator that may be used to determine your distributions, which will result in the lowest possible minimum distributions.

The Internal Revenue Service (IRS) applied this concept for all IRA owners regardless of who the beneficiary may be. However, there is one favorable exception: a spouse 10 years younger than the owner of the IRA will entitle the owner to the use of a calculated lower minimum distribution amount.

To determine your distributions, according to the IRS, first you need to calculate "the account balance as of the last valuation date in the calendar year immediately preceding that distribution." Then you must multiply this year-end balance by a fraction of which the numerator is one and the denominator for IRA owners is the "distribution period (determined from the MDIB table)" that is applicable. This distribution is limited to the vested account balance as of the date for the distribution.

I'll make this clearer. Jane Ira was born on October 15, 1931. She turns 701/2 on April 15, 2002, and her required beginning date (RBD) to start distribution is therefore April 1, 2003. If the value of her IRA on December 31, 2001, is $25,300, her minimum distribution may be calculated based on her age during the calendar year 2002, which in this case is 71. The distribution is $25,300 multiplied by 1, divided by her life expectancy, or 25.3 more years. This results in a minimum distribution of $1,000 ($25,300 multiplied by 1 divided by 25.3). This minimum distribution amount must be paid by April 1, 2003. Thereafter, minimum distributions must be paid by the end of each year. In each succeeding year, the life expectancy calculated will decrease and the percent of the year-end balance to be distributed will then increase.

Unlike the 1987 proposed regulations, the recalculation/MDIB method in the new rules will mean that IRAs are never exhausted. Even at ages over 115, the divisor will be 1.8. Thus, it is nearly certain that all IRAs will have some amount remaining that may be distributed to designated beneficiaries after the death of the IRA owner.

The lower level of required distributions will enable most IRAs to increase in value during the distribution period. Unless you live well into your mid- to late 90s, the value of your Ira when you pass away will exceed the value it was when you were 70.

Three major improvements of the new system deserve recognition. First, it eliminates the use of different tables for different individuals; the same MDIB table is used for most IRA owners. Second, it eliminates the use of the designated beneficiary's age to calculate the withdrawal. This means that changing the beneficiary to a different person, a trust, or a charity will have no impact on the withdrawal schedule. And third, it eliminates the confusing decision of whether to select recalculation.

BE WARY

There are certain factors to be aware of:

-Although the MDIB table results in a lower payout, the IRS may update the tables if deemed appropriate.

-Commentators have suggested that future minimum distribution requirements should be reduced if a person exceeds the minimum distribution for a given year. However, the IRS stated, "No credit will be given in subsequent calendar years for such excess distribution." The excess distribution does reduce the end-of-year value for calculating future distributions, but to carry it forward was considered to be too complex.

-If you do not take the required minimum distribution, there is an excise tax of 50% of the required minimum distribution. This is consistent with the prior 50% excise tax rule.

-If you have more than one IRA, the minimum distribution will be calculated separately for each IRA. However, the total distribution may be taken from any one of the individual IRAs. If, in addition to an IRA, you also have a 403(b) plan or Roth IRA, the distribution requirements must be calculated separately and withdrawn from the respective plans.

DESIGNATED BENEFICIARIES

Beneficiaries could include the surviving spouse, a nonspouse, a trust, or a charity. For each, specific rules apply:

-Surviving spouse -- For nearly all married couples, the surviving spouse will be the designated beneficiary. A surviving spouse may elect to treat the spouse's entire interest as a beneficiary in an individual's IRA (or the remaining part of such interest if distribution has commenced to the spouse) as the spouse's own IRA. The surviving spouse elects to redesignate the account in the name of the surviving spouse as the IRA owner.

If a spouse is the designated beneficiary and decides not to roll the IRA over into his or her own IRA, then there is a distribution to the spouse calculated by using the age of the spouse in the year after the IRA owner's death. For subsequent years, the IRS stipulates "the applicable distribution period is reduced by one for each calendar year." This means the spouse would have a distribution schedule following the former "no recalculation" method.

-Nonspouse -- For a designated beneficiary who is not the IRA owner's spouse, a similar payout method will be used. The expectancy will be his or her age in the year following the year of the Ira owner's death. Once again, for each calendar year, the applicable distribution period will be reduced by one. For example, a son or daughter who is 50 on the year after the death of the IRA owner has an applicable distribution period of 33.1 (Figure 2). The distribution at age 50 would be the end-of-year IRA value for the prior year, multiplied by 1/33.1. In the following year, the fraction will be 1/32.1. The denominator will be reduced by one each subsequent year until the fraction eventually becomes 1/1 and the entire balance is distributed to the beneficiary. If there is no designated beneficiary, then the distribution method will again be reduced by one for each calendar year. However, it will use the life expectancy of the IRA owner on the year of his or her death as the applicable distribution period.

If a class -- that is, not a specific, named individual, but a type -- is designated as a beneficiary, such as the donor's children, then the designated beneficiary with the shortest life expectancy will be used for the calculation. All of the beneficiaries of the class will receive the same distribution, based upon the age of the oldest beneficiary the year after the demise of the IRA owner. However, if a basis for separate shares can be established, then each child will be able to use his or her own life expectancy. As an example, a family class trust has as beneficiaries one generation only -- usually the children or grandchildren of the grantors -- but two trusts, one for each generation, are frequently established. The reason for a class trust is to cover unborn or unadopted children after the grantor has passed away, since a regular trust can only have living beneficiaries when established.

-Trust -- In some circumstances, a trust will be the designated beneficiary of a plan. In such a case, the formula using the ages of the trust recipients to calculate distributions for a stretched-out IRA can be used if the trust meets the following requirements:

-The trust must be a valid trust under state law.

-It must be irrevocable upon the death of the IRA owner.

-The beneficiaries must be identifiable.

-The appropriate documentation must be given to the plan administrator.

Any legal charitable organization can be one of the designated beneficiaries of any type of IRA, using a donor-advised family fund in a large charitable trust established for this purpose. (Most large mutual fund advisors have these.)

ADMINISTRATION OF IRAs

There is a new requirement that mandates reporting of minimum IRA distributions by trustees and custodians. The IRS will issue the forms and instructions for such reporting at a later date.

Model documents with the proposed regulations have not been issued as of this writing. This will take place only when the regulations are final. Trustees and custodians are recommended not to modify or amend current documents, since there may be document changes required by the issuance of final regulations. Once the final regulations are issued, the IRA documents may be modified to comply with all requirements.

You may submit comments on the proposed regulations in writing (include a signed original and eight copies).

PLANNING STRATEGIES

Since IRA owners must start minimum required distributions at or just after becoming 70, the distribution table averages around 25 in the 71­73 age range -- which, divided into 100, gives about 4% of the total IRA value for starting distributions. Most IRA owners should be averaging 6% to 9% annual rate of return and thus accumulate this excess gain in increased total value of their IRA account when they are in their 70s. Only in later years when payouts increase will all income and some of the IRA principal be distributed. For example, if you are earning 7%, your principal will not even begin to be touched until you are 85. If you are earning an 8% earnings rate, the age will be 87. If you are earning 9%, your principal won't be touched till you're 89. This means most of you will have from 40% to 80% more value in your IRA when you pass away than you will at age 70-1/2. If you have $100,000 in your IRA at age 70-1/2, it could end up having more than $150,000 by the time you are 90.

Remember, you may start applying the new set of rules during 2001. This allows several charitable planning options. You may designate a charity for a percentage of your IRA. When you pass away, the charity will receive that percentage in cash. Your children may then use the balance for stretching out their own IRAs.

Alternatively, you may choose to select a charitable trust for a surviving spouse or children as part or all of their IRAs. Since the trust is tax-exempt, the distribution may be made to the charitable trust upon your demise, and any balance of the IRA can still be used for stretching out the IRAs of children or other family members. The major advantage of the charitable trust for children is the opportunity to pay out mostly capital gains, even though the trust is funded with an IRA. (For more articles on preserving returns for your beneficiaries, visit Working-Money.)

IN SUMMARY

These proposed regulations are a commendable attempt to simplify tax law. You can use the new MDIB schedule, change beneficiaries with no consequence to minimum distribution schedules, and, given the lower rates of withdrawal required, it is certain most of you will have an increase in IRA principal to leave to your heirs.

Morley Hudson is a mechanical engineer and former Louisiana State Representative. He is a retired estate executor, trust manager, and investment manager.

SUGGESTED READING

Faber, Bruce R. [2001]. "The Bill That Didn't Pass," Working Money, Volume 2: April.
_____ [2001]. "The Money Tree Grows Slowly -- At First," Working Money, Volume 2: March.
Hudson, Morley [2001]. "Shake Uncle Sam Off Your Coffin," Working Money, Volume 2: May.

The new distribution rules are set forth in the proposed regulations under Sec. 1.401(a)-5 Required Minimum Distributions from Defined Contribution Plans. In this article, all references to regulations are taken from the proposed regulations in REG-13047700 and REG-13048100.