It's Christmas all over again for IRA owners and participants in employer sponsored retirement plans such as 401(k)s, 403(b)s, etc.  Without bothering to consult the president or the Congress, the IRS has made sweeping changes in the rules governing the distributions of IRAs and retirement plans both when the IRA owner reaches 70 ½ and after the IRA owner dies.

Though billed as "New Proposed Regulations on Required Minimum Distributions" for all practical purposes, the new rules are effective immediately.  (The previous set of proposed regulations in this area, passed in 1987, were never made final but practitioners have followed the proposed regulations as the law since 1987.)  The IRS has said "IRA owners may therefore rely on these proposed regulations for distributions for the 2001 calendar year."  IRA owners may continue to use the existing rules for the year 2001, but so far, I see no reason why anyone would want to.

If you are interested in learning what your new Minimum Required Distribution is, please visit my new Minimum Required Distribution Calculator.  Calculating your MRD for 2001 according to the new regulations is easy - simply plug in two entries:  your date of birth and the combined balance from your IRA and retirement plans and press "calculate."  You can also calculate it "manually" by using the new "Uniform Withdrawal Factor" table on the same site.

Unfortunately, retired employees, whose money is still in a company plan that has not amended their plan document can't use the new tables.

As I and other IRA experts have more time to read and interpret the proposed regulations, I will be sending out more information.  In the meantime, here is the second edition of this newsletter containing the "meat" of the new proposed legislation:

Background

Until now IRA owners and/or participants in most retirement plans were subject to extremely complex rules stipulating how much money they were required to withdraw from their IRA or retirement plan.  The minimum required distributions for IRA owners commenced when they reached 70 ½.  Some retirement plan participants could delay their minimum required distributions until after they retired.  Distributions from an IRA or retirement plan are taxable for federal income tax purposes. Given that, IRA owners who did not have an immediate need for the IRA distribution had a huge incentive to do everything they could to lower their minimum required distribution.

The amount of the minimum required distribution was calculated by dividing the balance in the account on December 31 of the previous year by a number derived from the life expectancy of the owner and the beneficiary.  There were different methods of calculating life expectancy including the recalculation method, the term certain method and even a hybrid method.  The minimum required distribution differed substantially depending on who was named as the primary beneficiary.  To make matters worse, once these elections were made, the IRA owner set in stone a distribution pattern that could not be slowed down after April 1 of the year following the year the IRA owner turned 70½.  If the surviving spouse was named the primary beneficiary but predeceased the owner, there was usually a massive acceleration of taxes both at the first and second death.  It was a mess.

New Law

The concepts of recalculation and term certain and hybrid with respect to calculating life expectancy are now only of historical interest.  With only one exception, the minimum required distribution is calculated based on the joint life expectancy factor of the IRA owner, starting at age 70, and the life expectancy of someone who will be considered to be ten years younger than the IRA owner, no matter what their actual age or life expectancy may be.  That life expectancy factor will decrease as the IRA owner ages.  "Using the MDIB table, most employees (the IRS also includes IRA owners) will be able to determine their minimum required distribution for each year based on nothing more than their current age and their account balance as of the end of the prior year (which IRA trustees report annually to IRA owners.)" The only exception is when your spouse is 10 or more years younger than you are.  In that case, the IRS will allow you to use your actual joint life expectancy.  Most participants who currently receive minimum required distributions will now be able to enjoy a lower minimum required distribution using the MDIB. The term MDIB is replaced with the "Uniform Table" because subject to the one exception mentioned, it applies to everyone.  You can determine your new MRD by using either my new calculator or the new "Uniform Withdrawal Factor" table.

Minimum Required Distributions After the Death of the IRA Owner

Planning for and applying the old MRD rules after the death of an IRA owner (now called the applicable distribution period) was like trying to cross a swamp of quicksand loaded with minefields.  The penalty for "getting caught" without a plan was a massive acceleration of income taxes for the heirs. Beneficiaries who did not immediately need the proceeds of the inherited IRA were better off leaving the money in the tax-deferred environment of the IRA. To achieve the "stretch" required thoughtful and complicated planning. Planners had to take into consideration a variety of factors including the named beneficiary when the owner turned 70 ½, whether the surviving spouse predeceased the IRA owner, the methods chosen to calculate life expectancies, and whether a special election, that had to be made by either the surviving spouse or non-spouse beneficiaries, was filed in a timely fashion. 

Under the new rules:

• If the beneficiary is the surviving spouse, the rules about making an IRA rollover into the spouse's own IRA are clarified, but not substantially altered. 
• If the beneficiary is a non-spouse, they will be required to take minimum required distributions over their life expectancy. 

When to Name a Beneficiary

We no longer have to worry about who was or was not the named beneficiary on April 1 of the year following the year the IRA owner turned 70 ½, i.e., the IRA owners required beginning date (RBD).  Now, the life expectancy of the beneficiary is determined after the IRA owner dies.  It is not dependant on who or how old the beneficiary was when the IRA owner reached his RBD.  In the words of the IRS "the designated beneficiary is determined as of the end of the year following the year of the employee's death rather than as of the employee's required beginning date or date of death."

In effect, the applicable distribution period is determined by the age of whoever is left standing on December 31 of the year following the year the IRA dies-in contrast to the old rule which determined the MRD based on the owner's beneficiary as of the owner's RBD.

The IRS will now allow post-mortem divisions to allow the last standing beneficiary to achieve a favorable stretch.

Example:

At age 70, an IRA owner names his 90-year-old mother for 25%, his 70-year-old spouse for 25%, his 40-year-old child for 25%, and a trust for his 5-year-old grandchild for 25% of his IRA.  He dies at age 72.

Under the old rules, all the beneficiaries had to use the life expectancy of the 90-year-old mother causing a massive acceleration of taxes and mortally wounding the stretch IRA (not to mention the fallout with the attorney that filled out the beneficiary designation).

Under the new rules, assuming it is divided in a reasonable amount of time, each beneficiary would be able to use his or her own life expectancy for their "applicable distribution period."

Furthermore, you have the flexibility to name anyone, or any organization as your beneficiary. As long as there is a beneficiary, you get the benefit of the reduced distribution from the new "Uniform Withdrawal Factor" table. Therefore, you could name a charity as your primary beneficiary and still enjoy a low MRD.  Good news for charities!

Don't Decide Now, Decide Later

The new law invites "disclaimer planning" opportunities.  In the past I have written extensively about disclaimer planning and now more than ever, disclaimer planning will be a significant strategy for individuals with substantial IRAs.  Previously, as a planner for larger estates with significant IRAs, I often advocated breaking up a large IRA into several separate IRAs.  I encouraged clients to name children and/or grandchildren as the primary beneficiary of some of the smaller IRAs to take advantage of tax deferred "stretch" of the IRA both during the life and at the death of the IRA owner.  However, most of my clients resisted naming a child and/or a grandchild as primary beneficiary, even for relatively small amounts, because they were nervous about money and wanted to "overprotect" the surviving spouse. (This was true even if they had several million dollars in their IRA.)  The uncertainty about who was going to die first and how much money would be available after the first death was too unsettling. They wanted to save taxes, but were reluctant to take away options for the surviving spouse.

Most clients preferred disclaimer strategies where we set up a "B" or unified credit shelter or exemption equivalent trust as the secondary beneficiary of the IRA.  This would allow the surviving spouse tremendous flexibility in either choosing to retain the entire account, disclaim to the "B" trust, or keep some for themselves and disclaim to a "B" trust.  (Please see my article, Retirement Planning for IRA Owners and 401(k) Participants).

However, clients that chose the "B" trust as contingent beneficiary route were likely to be giving up the maximum "stretch" for their IRA.  Now, since the critical date for determining the distribution pattern for the beneficiary is after the IRA owner dies, we can achieve the benefits of the "stretch" IRA by without having to name the children as primary beneficiaries.  (In fact, these changes will require me to rework many of my existing articles, including one that was just submitted to the AICPA for peer review that had an in-depth quantitative analysis of the old rules).

Under the new rules, we can provide the surviving spouse with the option to either:

• keep the IRA proceeds and rollover the IRA to his or her own IRA, or
• disclaim to his or her children in order to get an additional stretch and to avoid estate taxation at the second death.

This disclaimer strategy would not have worked under the old law because the MRD for the child after the surviving spouse had disclaimed would have been based on the life expectancy of the spouse, not the child. Under the new law the surviving spouse would disclaim sometime after the death of the IRA owner (but before December 31 of the year following the year of death, i.e., the date for determining the beneficiary).  If the spouse "disclaimed" within the allowable period, the children would be left standing when the time came to determine the "applicable distribution period."  The children would then achieve the "stretch" for the IRA.  Planning for individuals with large IRAs is now more like a delightful walk along a beach contemplating whether it would be more fun to stop at the lemonade stand or the ice cream concession.

At Bat with the New Law-The Estate Planning Home Run

The changes have inspired a new love:  "cascading beneficiaries with disclaimer options."

Consider the following:

• The primary beneficiary of the IRA would be the surviving spouse.
  
• The secondary or first contingent beneficiary could be a trust where the surviving spouse gets the income and at the death of the surviving spouse the proceeds go to the children equally.  (A "B" or unified credit or exemption equivalent trust).

So far, this is identical to one of my standard "old rule" plans.

Now, I am suggesting:

• The third beneficiary or second contingent beneficiary would simply be the children equally.
  
• The fourth or third contingent beneficiary could be a special trust for the grandchildren.

Under the old rules you could have had cascading beneficiaries, but it was not helpful in terms of slowing down the minimum required distribution of the beneficiary.  The critical date for determining a distribution pattern was the IRA owner's RBD, April 1 of the year following the year the IRA owner turned 70 ½.

Under the new rules, the critical date is December 31 of year following the year the IRA owner dies.  The extended time frame allows a family to leave options open for getting the longest "stretch IRA."  However, if circumstances dictate, it also preserves the safety net for the natural heir of the IRA owner, i.e., the surviving spouse.  The cascading beneficiary idea combined with a partial Roth IRA conversion will maximize the value of an IRA or retirement plan for many IRA owners and their families.

What's the Catch?

These are all extremely favorable changes.  But, it isn't the IRS's habit to confer a second Christmas in January.  The catch is that since it is so easy to calculate the minimum required distribution, the IRS is going to require the investment company that is holding your IRA (like Vanguard or Merrill Lynch or a bank) to report your projected minimum required distribution.  Then, if you fail to take and pay income tax on the minimum required distribution (which they will know because they will crosscheck the information Vanguard sends them with your tax return-much the way they currently crosscheck interest income), you are likely to be hit with a 50% penalty on the amount not withdrawn.  Though this penalty has been on the books for a long time, the IRS could not enforce the minimum required distribution rule or the penalty for failing to take the minimum required distribution because the calculation of the MRD was so complex.  The rules governing annuities will not change substantially.  The old rules will continue to apply.

The New Law and the Roth IRA Conversion

Before I make my suggestions, please let me defend myself against commentators who think I am wildly pro-Roth IRA conversion.  I always try to be objective, developing my recommendations on objective quantitative analysis.  I compare and contrast the effects of converting a portion of a traditional IRA to a Roth IRA versus maintaining the status quo and retaining all the money in a traditional IRA.  Please see my peer-reviewed article quantifying the economics of the Roth IRA conversion.  In fact, I usually recommend converting an amount considerably less than what I would deem optimal out of a certain respect for conservative strategies and trying to reduce the pain of having a client write a large check to the IRS for the Roth conversion.  That said, after an objective analysis is made, there are great benefits for "targeting" amounts for a Roth IRA conversion, both under the old and with the new law.

Though the new law does not really speak to Roth IRAs, it will have two substantial impacts on Roth IRA conversions. 

1. Many more clients will be eligible for the conversion. With a lowered MRD, more clients will fall under the $100,000 limitation that will now allow them to qualify for the Roth IRA conversion.
   
2. Roth IRA conversions will be slightly less desirable. The Roth IRA itself is no less desirable than it was before. The conversion, however, is less desirable because maintaining the status quo of owning a traditional IRA is a better choice than it has ever been.  The IRA owner will have a lower MRD.  The heirs will get a stretch.  Virtually all the traps and nightmares about massive income tax acceleration are a thing of the past.

A partial Roth IRA conversion is still good for many if not most qualifying taxpayers.  However, objectively, it is not as favorable as it was before the new laws.  Please see our article The Roth IRA:  Our Recommendations.

Conclusion

For IRA owners who comply with the law, there is really no downside.  The new law is basically good.  Of course with new laws come new opportunities.  It is possible, even likely, that a review of your retirement and estate plan and the beneficiary designations of your IRA or retirement plan will allow you to take full advantage of the benefit from the changes.

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Acknowledgements

I would like to thank Jane Bryant Quinn who graciously included my web site in her column; Natalie Choate for several ideas published in her work; and Greg Kolojeski for publishing my newsletter on Brentmark's fine web site, www.rothira.com.