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Why you should read this article

  • Learn how to engineer the minimum possible IRA or retirement plan distributions allowable
    under the law
  • Learn the importance of splitting up IRA’s into separate accounts for different beneficiaries
  • Learn about the importance of distribution management in income and estate tax planning
  • Learn how to easily avoid the most common bone-headed errors in the management of IRA’s and
    retirement plans

Background

The first regulations explaining the rules for making distributions from IRA and Qualified Retirement Plans
(QRP’s) were issued in 1987. These were extremely complex and presented taxpayers with a large number
of ways to make unwitting mistakes, usually centering around having to distribute out entire account balances
within one to five years after the account owner’s death.

The new regulations have been designed to be a lot more forgiving than their predecessors. They do not ensure
that all taxpayers will automatically have the optimal distribution schedules at their disposal, but reduce
the chance of gross mistakes being made by uninformed taxpayers. These regulations also clarify some of the
operating rules for IRA’s.

The new regulations also incorporate new mortality assumptions into the life expectancy tables that are used to
compute minimum distributions. Effective for the 2003 calendar year, the standards for minimum distributions
will be computed using these tables. The use of these regulations is optional for 2002.

IRA and QRP management is where income tax and estate tax planning meet

Individuals spend their entire working lives in building up tax deferrals. These are situations where the fair
market value of an asset is greater than its tax basis. The most common examples are accounts that contain
deductible IRA and pension contributions that have no tax basis at all.

Building up and maintenance of tax deferrals is like the holy grail of financial planning. The individual is
generating investment earnings from unpaid (deferred) taxes. Besides delaying the date at which taxes are paid,
these tax deferral strategies afford individuals with opportunities to permanently reduce the income tax on these
earnings. Consider the benefit of taking IRA distributions after retirement, when tax rates are lower than when
taxable wages are received.

The disposition of IRA and QRP assets on the death of the owner usually occurs outside of the provisions of
wills and trusts through the naming of a designated beneficiary. The only time that a will would control the disposition
of IRA assets would be if no beneficiaries were named. Trusts can be used to provide some flexibility
in directing IRA distributions, but at the price of adding an additional layer of complexity to the administration
process, and potentially accelerating distributions.

Were it not for liquidity concerns and the estate planning considerations, IRA and QRP distribution strategy
would be simple. We would just engineer the minimum required distributions and let the IRA assets grow.
One problem with this strategy can lead to a buildup of assets that may be subject to estate taxes. Another basic
problem is that keeping tax deferrals intact only works if cash is available from other sources to meet living
expenses.

IRA management is one of the pieces of both income and estate tax planning. Setting the appropriate strategy
involves dealing with conflicting objectives. To be done properly, these strategies must be tested as part of an
integrated analysis.

Key Changes in the regulations covering minimum distributions

  1. Distributions during the owner’s life are generally governed by a single table that assumes a 27.4 year
    life expectance for the individual at age 70.

    Previously individuals determined their distribution periods over the joint life expectancy of the owner and the
    designated beneficiary, or using a single life table if no beneficiary was named. This change puts individuals
    without family members to name as beneficiaries on a level playing field in making distributions. This is clearly
    a more equitable policy from an income tax perspective.

  2. If a spouse is the sole beneficiary of an account, distributions can be determined using joint life
    expectancies that are recomputed annually based on attained ages.

    Planning point: If the owner’s spouse is more than 10 year younger that the owner, this will produce a
    distribution period that is longer than the uniform 27.4 year table.

  3. Distributions are allowed after the death of the owner over the greater of the life expectancy of the
    designated beneficiary or the owner’s life expectancy using the 27.4 year lifetime distribution schedule.

    Planning point: There are still benefits to be gained by naming grandchildren as IRA beneficiaries.
    This can add 50 years or so to the distribution period after the death of the owner.

    Planning point: Consider naming the spouse as the primary beneficiary, with grandchildren as contingent
    beneficiaries. There is now no acceleration of lifetime distributions from naming an older spouse
    as the beneficiary. If a longer post mortem distribution period is attractive, the spouse can disclaim his
    or her interest in the IRA.

  4. Distributions to a surviving spouse are not required to begin before the year the owner would have
    attained age 70 1⁄2.

    Planning point: Older spouses that inherit IRA’s may be able to defer distribution longer by remaining
    as beneficiaries rather than rolling over the account into their own IRA’s.

  5. IRA assets can be divided into separate accounts with different beneficiaries at any time through
    December 31 after the year of the owner’s death.

    The new regulations provide that if a common account is maintained for multiple beneficiaries, the minimum required
    distribution would be based on the age of the oldest beneficiary. However, if separate accounts are maintained
    that have different beneficiaries, the minimum distributions for each account are determined separately.

    Since all non-spousal accounts will now have the same lifetime distribution schedule, the new regulations allow
    for segregation of assets into separate accounts after the owner’s death. This provides the benefit of:

    • allowing investment strategy to be tailored to the needs of each beneficiary, and
    • using the life expectancy of younger beneficiaries to determine the minimum distributions from their
      respective accounts, increasing the distribution period.

    From the perspective of simplifying IRA administration, this is potentially the greatest benefit conferred by the
    new regulations. It pushes back the date for making important decisions regarding division of IRA assets, and
    sets the table for doing post death planning through the use of disclaimers by primary beneficiaries.

    Planning point: The deadline of December 31 in the year after death for segregating assets into separate
    accounts is critical. If this is not done, minimum distributions to all beneficiaries are based on the
    age of the oldest beneficiary, regardless of how the assets are subsequently segregated.

  6. The determination of designated beneficiaries for the purpose of computing minimum distributions is
    determined on September 30th in the year following the owner’s death.

    The regulations state clearly that in order to be a beneficiary, an individual must be specified as such on the date
    of the owner’s death. Executors or trustees cannot add beneficiaries. However, beneficiaries can be removed,
    either through distribution of their entire benefit or through disclaimer. This allows post death planning to remove
    those individuals as beneficiaries where it would cause an acceleration of distributions. Older beneficiaries
    could disclaim in favor of younger ones that had been named contingent beneficiaries.

    Planning point: The deadline for disclaiming an inherited asset is nine months after the owner’s death.
    The September 30th deadline is an administrative deadline for determining minimum distributions. It
    does not extend the deadline for making a disclaimer.

  7. The new regulations allow for the designation of successor beneficiaries for IRA or QRP accounts.
    A successor beneficiary is an individual who obtains an economic interest in an account after the death of a
    primary beneficiary. This can occur when the primary beneficiary has been given something less than absolute
    ownership over the account, such as the power to receive account’s income for life, but not principal.

    Planning point: Most standard IRA agreements offered by financial institutions are not set up to accommodate
    such features. This requires drafting custom beneficiary designations or making a trust the
    account’s beneficiary (with the appropriate features in the trust agreement). Financial institutions are
    generally reluctant to have standard account agreements modified. If anything other than the standard
    agreement will be used, acceptance of modifications by the institution should be worked out in advance.

    Planning point: Under most standard IRA agreements, an individual’s status as a contingent beneficiary
    ends if the primary beneficiary is alive at the time the account owner dies, unless the primary beneficiary
    disclaims his or her interest in the account. If it is the intention of the owner to keep the account alive
    after the death of the primary beneficiary, then modification to the standard IRA agreement or use of the
    trust are needed. Non-spousal beneficiaries do not have the ability to name successor beneficiaries of
    an account.

  8. There is now no time limit for surviving spouses to make IRA rollovers where the surviving spouse is
    considered to be the account owner.

    Becoming an account owner allows the spousal beneficiary to name the beneficiaries of an account, and to
    change the minimum required distributions from the account. The new regulations make it clear that this election
    can be done at any time after the death of the account owner. This election is not available for accounts
    with any non-spousal beneficiaries.

    Planning point: This election is done by simply retitling the account to designate the spouse as the account
    owner.

    Planning point: This election is not available if a trust is the IRA beneficiary, even if the surviving
    spouse is the sole beneficiary of the trust. Where spousal rollovers are attractive for minimizing required
    distributions, trusts should not be used as beneficiaries.

    Planning point: For individuals who have previously inherited IRA’s from spouses, this is an ideal time
    to review whether an account rollover should have been done.

    Planning point: Just because there is no deadline for the surviving spouse to roll over the IRA does not
    mean that individuals should wait. If the surviving spouse dies before the rollover is completed, the opportunity
    to name beneficiaries is permanently lost.

  9. Use of trusts as IRA or QRP beneficiaries requires that certain trust documentation be provided to the
    plan administrator:

    • a copy of the trust agreement and amendment, or
    • a list of all trust beneficiaries

    If the account owner wants to designate the spouse as the sole beneficiary of the benefits and use the joint life
    tables (vs. the uniform 27.4 year tables for non-spouse beneficiaries), this documentation must be given to the
    plan administrator before distributions commence. Otherwise, this documentation only has to be given to the
    administrator by October 31st of the year following the owner’s year of death.

Summary

A clear understanding of these minimum distribution rules is needed to maximize the benefits of IRA and retirement
plan tax deferrals. Everyone’s situation is different, and careful planning is needed to make the proper
trade-offs between tax saving strategies and liquidity concerns.

Common IRA/QRP Administration Errors

  • Assuming that the distribution rules for your Qualified Retirement Plan are the same in the new
    regulations.

    Employers adopt retirement plan. These may be more restrictive than the minimum standards for distributions
    in the new regulations. For example, a retirement plan could require that all assets be distributed within 5 years
    of the death of the account owner, regardless of beneficiary designations. Just because a more liberal feature is
    available under the Internal Revenue Code does not automatically make it available to plan participants.

    Action: All IRA account owners should review the IRA account agreements to determine if they contain
    any undesirable features.

    Retirement plan account owners should review plan documents for the same. Lump sum distributions
    done in conjunction with rollovers to IRA accounts can be used to sidestep restrictive plan features.

  • Missing making the minimum IRA distributions.

    There is a 50% per year excise tax on any shortfall in distributions. The new regulations make it clear that excess
    distributions in one year don’t offset shortfalls in other years.

    Action: Prepare distribution schedules from the applicable tables for each account.

  • Not considering how to maximize the distribution period at the death of the account owner.

    In conjunction with splitting the IRA into separate accounts, this can be accomplished by having grandchildren
    as beneficiaries or allowing a younger surviving spouse to elect to have the account treated as his or her own.

    Action: Segregate IRA assets into separate accounts for the different beneficiaries.

    Avoid imposition of the 5-year distribution rule by starting distributions to non-spousal beneficiaries in
    the year following the owner’s death, using life expectancies from the single life table.

  • Not allowing for post mortem tax planning through the use of disclaimers.

    The effect of a disclaimer is that the beneficiary is considered to have predeceased the account owner. If there
    are multiple primary beneficiaries, selective disclaimers may not direct the benefit to the intended parties.

    Action: The effect of all potential disclaimers should be reviewed to ensure that primary beneficiaries
    have tax planning opportunities of their own.

  • Not providing for payment of estate taxes from on-IRA or QRP sources.

    What is the point of building up tax deferrals in these accounts if large distributions will be required to pay
    estate taxes?

    Action: Determine who should be responsible for bearing the estate tax and draft wills and trusts that
    provide for the payment of estate taxes from sources other than IRA’s or retirement plans so tax deferrals
    are preserved.

  • Not planning for Roth IRA conversions.

    The two main advantages of Roth IRA’s is that the income earned in the account is exempt from income taxes,
    and no distributions are required during the owner’s life. If distributions commence in the year following the
    owner’s death, they can be made over the designated beneficiary’s life expectancy. The tax exemption feature
    is especially important because as taxpayers get older, tax deferrals on regular IRA’s and retirement plans are
    gradually eliminated by distributions. Converting regular IRA’s to Roth IRA’s reduces required lifetime
    distributions.

    Action: Look for years where Roth conversions can be made at low tax cost.