Finally, They're Finalized IRS Enacts New, Better Retirement Plan Distribution Rules

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Tax-deferred retirement plans — such as traditional IRAs, 401(k)s and Simplified Employee Pensions (SEPs) — have long been popular savings vehicles. Many people well know they generally can’t withdraw money from these accounts before age 59¹/₂ without paying a 10% penalty in addition to regular income tax. But they seldom consider that eventually Uncle Sam will require them to take minimum distributions or face a much bigger penalty. And the rules for taking these distributions can be complex enough to bewilder even the savviest retiree.

To help taxpayers, the IRS proposed a set of distribution regulations in 1987. Unfortu­nately, these rather tentative rules only increased many people’s confusion. So last year the agency put its money (or yours, actually) where its mouth was, swapping its late-80s proposed regulations for new (also proposed) ones that, relatively speaking, simplified the process.

This year the IRS has gone one better, slightly revising last year’s proposed rules and finalizing them to apply to all distribu­tions beginning in 2003.

Although you may use any of the three sets of regulations in the meantime, you’ll likely benefit most from this final version. (And you’ll have no choice next year.) So let’s examine how these new rules can help you get more from — and incur less tax on — your retirement plan.

The New and Noteworthy

Perhaps the most significant rule change is how the IRS determines your distribution period (the time during which you or a bene­ficiary will receive plan funds) and, therefore, the amount of your required minimum distri­butions. Before last year’s proposed rules, the government required you to calculate your remaining life expectancy on the basis of beneficiary desig­nations and either the recalculation or term certain method.

The new rules follow a uniform life expec­tancy table — which reflects improved life expectancies and generally reduces required minimum distributions — for everyone. (One exception: A “Joint and Last Survivor” table applies if you name your spouse as benefici­ary and he or she is more than 10 years younger than you.) Smaller minimum required distributions are beneficial because they allow more of your retirement assets the opportunity to grow tax deferred longer.

Old News That Remains Important

What the new rules don’t change is the required beginning date, on which you must start taking plan distributions. It remains April 1 of the calendar year following the year in which you reach age 70¹/₂. Thus, if you turn 70 on June 30, 2003, you’ll reach 70¹/₂ on Dec. 30, 2003 and your required beginning date will be April 1, 2004. But if you turn 70 on July 1, 2003, you’ll reach 70¹/₂ on Jan. 1, 2004. In this case, your required beginning date will be April 1, 2005.

To calculate each year’s minimum required distribution amount, you simply divide your account’s previous year end balance by the “joint life expectancy divisor” indicated in the uniform life expectancy table. (See “Applicable Divisors for Required Minimum Distributions” at the end of this report.)

When looking at the table, you’ll notice that the younger your age, the bigger the divisor and the smaller the required distribution amount. This is a good thing, because it allows any money you leave in the account to continue growing tax deferred.

What happens if you don’t take a minimum required distribution? You’ll have to pay a 50% penalty on any amount you should have withdrawn but didn’t — along with income tax on that amount.

Plus, you must then take two minimum dis­tributions in the next year and incur a double tax hit. This circumstance may push you into a higher tax bracket, adversely affect your adjusted gross income (which is used to determine your eligibility for various deduc­tions, exemptions and cred­its) and even expose more of your Social Security benefits to taxation.

Rules for Postdeath Planning

Of course, after your death, the rules change somewhat. For instance, if you die before your required beginning date with a desig­nated beneficiary in place, the plan will dis­tribute assets on the basis of the benefici­ary’s remaining life expectancy.

If you don’t have a designated beneficiary in this situa­tion, the “five-year rule” applies. It requires distribution of the entire account balance within five years of your death. In most cases, this will significantly increase the size of the required minimum distributions and greatly reduce the opportunity for tax-deferred growth.

On the other hand, if you die on or after your required beginning date with a designated beneficiary, that person’s remaining life expectancy (based on the “single life” table and calculated in the year after your death) will determine the distributions. Under the new rules, the required minimum distribution will be the greater of the beneficiary’s life expec­tancy or your life expectancy, using your age (as of your most recent birthday) during the year of your death and reducing your life expectancy by one in each subse­quent year.

Should you die on or after your required beginning date without a designated benefici­ary, distributions will go to your estate according to your remaining life expectancy. The distribution amount will be calculated using your age (as of your birthday) during the year you die and reducing your life expec­tancy by one in each year thereafter.

Bear in mind that a special rule applies if your spouse is your plan’s sole designated beneficiary. He or she can elect to roll over the plan into his or her own IRA or simply retain the plan in your name. In this case, he or she can defer distributions until the year you would have reached your required begin­ning date. Doing so can especially bene­fit your spouse if he or she is already 70¹/₂ and you’re younger, because the account can grow tax deferred until you would have reached your required beginning date.

The Beneficiary Necessities

Even after the 2001 proposed rules, many taxpayers remained uncertain about whether they could add a beneficiary after a plan owner’s death. The new, finalized rules clar­ify that, for his or her life expectancy to be used when determining minimum required distributions, a beneficiary must be named before a plan owner dies.

On the bright side, the IRS has moved up the final determination date for identifying bene­ficiaries from Dec. 31 to Sept. 30 of the year following the plan owner’s death. This gives beneficiaries more time to calculate and receive their minimum required distributions before year end, when distributions to non­spouse beneficiaries must start.

Thus, to plan effectively, you absolutely must choose your beneficiary as soon as possible and, if necessary, update this choice regularly. Failing to do so will likely mean higher minimum required distribution amounts and significantly less opportunity for tax-deferred growth.

Your Next Move

As mentioned, these new rules take effect on Jan. 1, 2003. And, in the meantime, you can choose either these or one of the two previously proposed sets. Yet even in the event the older rules may still benefit you, these new rules are final and will eventually affect your retirement plan. That’s why you needto learn as much as possible about them while you still have some breathing room. 

(c)2001-06 Fraser CPA - Last Updated 05/01/2006