Today we look into the future when individuals plan to withdraw their fund(s).

In Part I of this series we looked at the new tax law, retirement programs and how much cash individuals may contribute to different retirement plans. In this part, we look into the future when individuals plan to withdraw their fund(s). Last January, proposed regulations were issued on minimum required distributions (MRDs) that are supposed to be effective as of January 1, 2002. These new laws will simplify distributions for individuals and businesses that have qualified retirement plans.

There have been several interesting changes with regards to figuring minimum required distributions (MRDs) from qualified retirement plans and traditional IRAs. (These new changes will not affect Roth IRAs.) There are essentially three significant opportunities that will be available. They are:

A single method for figuring lifetime MRDs, with one exception

Computations for figuring both lifetime and post-death distributions

The obligation to designate a beneficiary by the required beginning date (RBD).

Under the law, lifetime MRDs were calculated by using one of three methods: the term method, the recalculation method, and the hybrid method. An individual was required to choose a method before turning age 70 1/2.This system caused great confusion trying to calculate each year’s required MRD. Consequently, the new method is looking to place a uniform table into practice. The benefit of using a uniform table is that it has the computations of frequent occurrences installed such as: whether or not there is any designated beneficiary and whether such a beneficiary is younger or older than the individual. Following is the table that will be used to calculate the MRD.

This table is much easier to use than the one that has been mandatory since 1987. An individual merely uses his age as the “applicable divisor” at the end of the year to figure his/her MRD. Then, the account balance of the retirement plan at the end of the previous December 31 is divided by the applicable divisor to acquire the MRD. The following year the individual will again consult the table to uncover his new MRD based on his age and applicable divisor for the new year.

Following is an example demonstrating the difference between the old and new methods. Let us assume an individual with an IRA of $250,000 on December 31, 2000, has turned 70 1/2 in May of 2001, and commenced MRDs on December 31, 2001, without designating a beneficiary. The first MRD would have been $16,340, which is $250,000 divided by 15.3 for age 71.

If we consider the same scenario under the uniform table, the current method’s figure would be $9,881.Thus, the current amount would be reduced. The same individual would divide the $250,000 from their retirement fund by 25.3, the applicable divisor for age 71. It is easy to notice the new method gives individuals the opportunity to increase their accounts tax-deferred. (In this case, the difference is cut by 40%.)

Remember, there is an exception. The exception applies when a designated sole beneficiary of the IRA is the individual’s spouse and is more than 10 years younger than the individual. When this occurs, the couple’s actual joint life expectancy can be used to figure their MRDs, which is taken from the old IRS joint life expectancy tables. In cases such as these, smaller MRDs may be taken from the older expectancy tables, rather than the new uniform table.

As a side note, the new rules permit those who have already been taking MRDs to effectively correct past mistakes such as: not naming beneficiaries or being unhappy with the decision made with their current distribution method. As a result, regrettable past decisions are completely eliminated. By having the ability of overriding the old rules, this gives individuals the capability of avoiding the 50% penalty on insufficient distributions. The 50% penalty often comes into play when taxpayers relied on MRD information from custodians or trustees and later received insufficient withdrawals due to faulty information.

Much has been changed with regard to post-death distributions. Post-death distributions must be taken after the owner’s death in order to steer clear of penalties on underdistributions. If this transpires, then the designated beneficiary looks to the single life expectancy table to calculate his MRDs. Decisions on post-death distributions must be made no later than December 31 of the year following the year of the owner’s death. If the beneficiary fails to take post-death distributions based on the single life expectancy, then the entire amount must be distributed no later than the last day of the fifth year after the year of death.

The new rules have allowed an exception in cases where an individual dies before taking his/her MRD for the year. Under the old law, if an individual passed away before taking his/her MRD for the year, the distributions were still required in order to avoid the 50% penalty on underdistributions. However, under the new rules, if the remainder of the account is distributed over the course of five years following the year of death, then the 50% penalty is waived.

Lastly, a beneficiary does not have to be listed as a designated beneficiary until the end of the year following the year of the owner’s death. Under the new law, a beneficiary may disclaim a bequest. To take advantage of this change, a beneficiary may pass the benefit on to a younger family member to obtain a longer tax-deferred build-up.

There are additional options that may be chosen which deal with post-death beneficiary planning. For example, an individual may buy out the interest of a charity that has been selected as one of the retirement fund beneficiaries so that the MRDs could be figured over the other beneficiary’s life expectancy. The added flexibility given to this selection of the tax code makes a number of alternatives available depending on your circumstances.

In instances, when a trust is named as the designated beneficiary, the life expectancy of the oldest trust beneficiary is used to figure post-death MRDs. (This does not change under the new rules.) If the terms of the trust have the distributions paid to a primary beneficiary, then only the primary beneficiary’s life expectancy is used to determine post-death MRDs.

However, if the terms of the trust state that income and/or principal of the funds are to be accrued during the course of the primary beneficiary’s life for the benefit of secondary beneficiaries (remainder), then the secondary beneficiaries are included in the class of designated beneficiaries to determine which beneficiary has the shortest life expectancy.

It is easy to be bogged down in terminology; to make it easier, here is another example: Suppose a son or daughter age 54 inherits an IRA from a parent. The following year the son or daughter begins to receive distributions from the account. The applicable divisor from the single life expectancy table for age 55 is 28.6. If the parent dies 12 years later, the applicable divisor would have been reduced to 16.6. (The original number minus one for each subsequent year.) The grandchild now inherits what is remaining in the grandparent’s IRA from his parent and continues to use the parent’s remaining applicable divisor for the rest of the IRA distributions.

Under the prior law, a surviving spouse who inherited an IRA might have rolled over the inherited IRA and treated it as his own, meaning the surviving spouse did not have to take distributions until he/she reached age 70 1/2. However, the new changes cause an exception to the rollover option. The spouse must have full control of withdrawals and be the sole beneficiary of the owner’s fund in order to roll the IRA over to their own account and recover full deferral. If full control does not exist, then the rollover is not allowed.

Finally, from an employers’ aspect, retirement plans will have to be amended to reflect the new changes once a new method is implemented. Thus, employers who offer qualified plans should meet with their retirement plan advisors to review existing documents and prepare themselves for changes to make the transition of the new rules easier on their employees and themselves.

With all the changes in the tax code this year, it is important not to overlook the retirement section. The new retirement and distribution rules provide for more versatility for beneficiaries and make distribution calculations almost effortless. It is essential to note the effects for the changes for planning and figuring distributions on retirement plans in the upcoming years. The following are important points to consider:

  • The ability to correct past errors on distribution method choices.

  • The ability to minimize yearly distributions to your advantage.

The ability to simplify future calculations.

Moreover, those who have already started taking distributions should look closely at the new changes and consult a tax advisor to calculate new minimum distribution requirements.

Whether you are planning towards the future or planning for today, knowing the new retirement and distribution changes in the tax code will benefit you and your beneficiaries.

If you have any questions pertaining to retirement planning or any other financial matter contact Bart Basi at The Center for Financial, Legal & Tax Planning, Inc.; 108 E. DeYoung, Marion, Ill. 62959; 618-997-3436; fax 618-997-8370; www.taxplanning.com; e-mail: b-basi@taxplanning.com.

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