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On January 11, 2001, the Internal Revenue Service issued new IRA
distribution rules in REG-13047700 and REG-13048100. These new
rules completely replace the former methods for determining IRA
minimum distributions, and will greatly impact anyone with an
IRA.
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The
new rules will be optional for the year 2001 and
mandatory for the year 2002.
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Given
the lower rates of withdrawal required, it is virtually
certain that most individuals will have an increase in
the IRA principal at the time they pass away. Since the
distributions start at about 4%, most IRA owners will
earn 6% to 9% and thus accumulate excess income during
his or her 70s. Only in later years when the payouts
increase will all income and some of the IRA principal
be distributed.
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Example:
An IRA owner earning 7% will not start to invade
principal until age 85. For an 8% earnings rate,
the invasion starts at age 87. A person earning
9% will not start to invade principal until age
89. Thus, the vast majority of the individuals
will have from 40% to 80% more value in their
IRA when they pass away then they do at age 70½.
Many persons with $100,000 at age 70½ will
pass away at age 90 with over $150,000 in their
IRA. |
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For
those individuals who have been fortunate in seeing substantial
growth in their IRAs over the past few years, it will be
important to consider methods of integrating these important
assets in their estate plans, both during retirement and
following the death of the participant. Beneficiary designations
must be reviewed and perhaps changed to accommodate tax and
distribution planning objectives. Property agreements among the
spouses and disclaimer planning are among the tools that
participants may wish to employ to effectuate tax and non-tax
estate planning goals.
For additional information concerning IRAs, select from any of
the topics below.
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IRS
Simplifies Rules for Withdrawing Tax-Deferred Funds
In
a surprise move, the Internal Revenue Service has
dramatically simplified distribution rules for
tax-deferred retirement plans, allowing retirees to take
less money out of their accounts each year--and
pay less income tax in the process.
The proposed changes affect the millions of Americans
who contribute to any of several types of tax-favored
retirement plans, including individual retirement
accounts, 401(k) plans, 403(b) plans, and 457 plans, as
well as millions of future retirees and their heirs.
Though subject to public comment, the changes went into
effect retroactively at the beginning of this month.
“These [changes] caught everybody out of the blue,”
said Stephen J. Silverberg, president of the Pension
Council of Long Island and managing partner of
Silverberg & Hunter in Garden City, N.Y. “It is
really a good and significant change. It benefits almost
everybody.”
The rules create a simple formula for calculating a
retiree’s minimum distribution amount, replacing amore
complicate system.
Previously, people with tax-deferred retirement plans
such as IRAs and 401(k)s had to make an irrevocable
“election” by April in the year after they turned 70½.
That decision determined how quickly they had to deplete
the money in those retirement plans.
The
old minimum distribution rules offered eight choices and
little guidance as to which was the
best choice for a given retiree. And once an election
was made, a retiree was stuck with it forever, even if
it meant taking more money out of the retirement plan
each year than was needed. Not
only would that mean
paying additional |
income tax, but it would also leave
less money in the account to grow tax-deferred.
Moreover,
if an account holder died without making proper
beneficiary elections, heirs could be forced to deplete
the account almost immediately, often paying income tax
at the highest marginal rates.
The new rules eliminate these problems. Not only do they
make it easier to figure out how much needs to be
withdrawn from a retirement account each year, they also
allow current retirees to go back now and make changes
in their withdrawal schedule.
Beneficiary designations also can be made posthumously--up
to Dec. 31st in the year after the account
owner’s death--thanks
to these revised regulations.
Here is how the new rules work and how they affect
retirement-account owners.
Q
Why are the changes important?
A
At age 70½, owners of IRAs, 401(k)s and other
tax-deferred retirement accounts have to start
withdrawing money from the accounts and pay the deferred
income tax on the amount they withdraw. The reason: The
IRS wants to collect the deferred tax before the account
owner dies.
However, many retirees want to minimize the amount hey
withdraw from their tax-deferred accounts to avoid
paying income tax on money they don’t need.
The previous rules gave taxpayers eight choices to
figure their required distribution. The formulas were
complicated, and each resulted in a different annual
amount.
The
new rules simplify matters by letting retirees use the
formula that allows the least amount of money
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to be
withdrawn from an account each year--resulting in the
lowest tax bill.
Retirees
can calculate the withdrawal amount by using an
age-related divisor provided by the IRS (See
accompanying chart).
There is an exception: If a spouse is the IRA
beneficiary and that spouse is more than 10 years
younger than the IRA account owner, the distribution
formula would be based on the actual ages of the account
holder and the beneficiary. That allows such couples to
stretch out distributions over the longest possible
period.
Q
What if someone wants to take out more money than the
formula requires?
A
That’s always allowable. The IRS restricts you only
from taking out less.
Q
Don’t these “proposed” rules have to be finalized
before they go into effect?
A
No. The rules on retirement-plan distributions that
taxpayers have been following for 26 years have never
been finalized. This new proposal is a revision of those
past, proposed rules, all of which were
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treated as the
law of the land from the moment they were published.
Q
Why would the IRS do this if it meant that everyone can
pay less tax?
A
Under the old rules, no one knew precisely how much any
given retiree should be taking out of his or her
retirement account. Retirees had to figure it out
themselves and compliance was on the honor system.
Under the new rules, retirement-plan trustees must
calculate the minimum required distribution for account
holders and then report that amount to the IRS, making
it much easier for the agency to track compliance.
Q
What happens to beneficiaries when an account owner
dies? Do they have to withdraw all the money from the
account immediately?
A
Assuming the beneficiary is valid, he or she can now
take withdrawals from the retirement account over time.
If an IRA is left to a spouse, for example, he or she
would be able to roll it into a new IRA, name a new
beneficiary--such
as a friend or a child--and
then start making withdrawals based on the new minimum
distribution tables. |
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Return
to IRA Options
New
IRS Rules for IRA Distributions
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A
simple Uniform Table is to be used for all employees. Regardless
of the age of a designated beneficiary, IRA owners will use the
same table. The age of the beneficiary will not make a difference,
except for a spouse who is more than 10 years younger than the
account owner.
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There
will be no decision to recalculate or not recalculate life
expectancy. With the 1987 proposed regulation method, the
potential for recalculating for both the owner and the designated
beneficiary created four different option possibilities. Even with
sophisticated software, it was difficult to make rational
comparisons of the benefits and detriments of the different
options. Thus, the new, single table uses recalculation for the
account owner to calculate the minimum distribution. Please see
the Uniform
Table of distribution calculations at right.
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It
is now possible to change the beneficiary at any time. Under the
current rules, changing a beneficiary can lead to larger
distributions, but never smaller distributions, even if the new
beneficiary has a longer life expectancy. The new system will
allow complete freedom to select designated beneficiaries, with no
impact on the minimum distribution requirement.
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The
beneficiary must be determined by the end of the year following
the death of the owner. This provision allows for disclaimers and
cashing out of some beneficiaries. The “Stretch IRA” may then
be available for the remaining beneficiaries.
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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. Generally, this new method
will reduce required distributions for the vast majority of IRA
owners and beneficiaries.
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Return
to IRA Options
Planning
Tips During the Life of the Participant
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If
you have already reached 70½, you may wish to wait until the
IRS makes it clear that you can use the current Uniform Table
before taking your 2001 minimum distributions from your Plan.
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If
you have already attained the age of 70½, you now have the
opportunity to change your beneficiary designation on your IRA
to afford your heirs greater flexibility and income tax
deferral following your death, no matter which elections you
made prior to your Required Beginning Date (RBD).
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Return to IRA
Options
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Estate
Planning Tips for Beneficiary Designations
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Bypass
Trust Funding: If
the participant’s IRA/Plan has grown in value to the extent
that it is equal to or larger than the value of the family home,
the participant and his or her spouse may need to institute special planning to be able to fully fund the Bypass Trust upon
the death of the participant.
Typically,
the surviving spouse will be named as the designated beneficiary
of the IRA or Plan. This may or may not be a good idea, as shown
in the illustration at right, wherein the Credit Shelter (Bypass
Trust) will be under-funded if the spouse is named as the
designated beneficiary of the IRA.
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Example:
A
husband and wife have a Community Property (CP) estate
worth $1.5 million (the estate is made up of the
following: the husband has an IRA worth
$600,000 and other CP Trust assets (stock, cash, house)
worth $400,000. The wife has an IRA worth $100,000 and
other CP worth $400,000. The combined assets equal $1.5
million). The husband dies and the wife,
as designated beneficiary, rolls her husband’s IRA
into her name. Now the executor of the decedent’s estate
has only $400,000 (the CP amount) to fund the Credit Shelter Trust or
Bypass Trust (not the full $675,000 Exemption Credit
allowed by the IRS that could have been allocated to the Bypass
Trust). The
surviving spouse now has $1.1 million in her estate with
$400,000 in the Bypass Trust.
If
the surviving spouse dies the following year, only her
Credit/Exemption Equivalent (currently = $675,000) and
the $400,000 allocated to the Credit Shelter (Bypass)
Trust would be exempt from estate taxes. Now $425,000 is
exposed to death taxes ($1.1million – $675,000 =
$425,000). This would result in an estate tax of
$166,250!
With proper planning, the Bypass Trust could
have been fully funded with the couple's other community property
assets by effectively using each spouse’s unified credit
of $675,000. The Bypass Trust would then have been funded with the
husband’s $675,000 on his death. If the surviving
spouse should die the following year, without any
additional planning, there would be a taxable estate of
only $150,000 ($1.5 million –
$1,350,000 = $150,000). The resulting estate tax would
be only $57,000, a savings of $109,000! ($166,250 –
$57,000 = $109,000) |
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Return to IRA
Options
Planning
Opportunities Following the Death of the Participant
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Failure
of a decedent to name a designated beneficiary prior to his or
her RBD or prior to his or her death may be curable through post
death action by the executor and/or beneficiaries of the estate.
Prior law required the participant to make an irrevocable
election as to the beneficiary(s) of his or her IRA or Plan,
either prior to the participant's RBD or before death, whichever
came first. If the participant made no election, e.g., had no
designated beneficiary, then the IRA under the terms of the IRA
instrument would be payable to the decedent's estate. Under the
new proposed regulations, the IRS gives us an extended period of
one year following the date of death of the decedent.
The transfer to the children does not trigger any income tax
because it is an assignment of the right to receive Income in
Respect of a Decedent (IRD) to the
person(s) who is entitled to receive the IRD under the decedent's
Will or Trust. Separate accounts can be created for children and
each can then defer the income taxes over their respective life
expectancies.
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Example:
Assume that following the death of the participant, the
executor/trustee (without taking any distributions of the IRA)
transfers the IRA account equally to the two children of the
decedent who are the residuary beneficiaries of the decedent’s
estate. This is accomplished before the end of the year
following the date of death. The estate of the decedent is not
in receipt of the IRA, but the children have now become the
“designated beneficiaries.” |
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A
surviving spouse or child of the decedent can now disclaim the
IRA and a younger contingent beneficiary can disclaim the new
designated beneficiary. (To
"disclaim" is to renounce a bequest or gift.)
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Example:
A parent gives one of her children, Sarah, $5,000. She
writes in the gifting letter that if Sarah doesn't want
the gift (i.e., Sarah disclaims it) then the gift goes
to Sarah's children. Within 9 months of the gift
(assuming Sarah doesn't spend any of the money), Sarah
can disclaim the gift and the $5,000 goes to Sarah's
children. |
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It
appears that the executor can now establish separate accounts if
there are multiple individual and/or individual and
non-qualifying non-individual beneficiaries after the death of
the participant. If separate accounts are established by the end
of the year following the date of death, then each separate account
is considered independently for purposes of determining required
distributions to the beneficiary of that account.
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