General Practice, Solo & Small Firm DivisionMagazine

American Bar Association
General Practice, Solo, and Small Firm Division
The Compleat Lawyer
Spring 1998
© American Bar Association. All rights reserved.

Minimum Distribution Planning for IRA and Retirement Plans

BY DESIREE M. PLAUCE & KARYN M. CRAVENS

Desiree M. Plauche, J.D., and Karyn M. Cravens, J.D. are Consulting Attorneys with the Agency Support Group of The Equitable Life Assurance Society, based in Alpharetta, Georgia. The Agency Support Group provides technical support and case design for Equitable associates across the country. The authors wish to express their appreciation to the members of the Agency Support Group for assistance in the preparation of this article.

The benefits of contributing to qualified retirement plan and IRA (QP/IRA) accounts are well known. Funds in QP/IRA accounts are not subject to income taxes until distributed to a plan participant or beneficiary.

Income taxes cannot be deferred indefinitely, however, because the government wants these funds used for retirement. Once funds are distributed, income taxes must be paid. In addition, any funds remaining in a QP/IRA account at the participant's death may be subject to estate taxes.

A complex set of rules determines when and how much a participant (or beneficiary) must withdraw each year from QP/IRA accounts. Failure to comply with these rules results in a 50 percent penalty on any amount required but not distributed to the participant.1 These rules are designed to deplete QP/IRA accounts over the life of the participant, or the joint life of the participant and the beneficiary. Minimum distribution planning helps participants maximize income tax deferral of QP/IRA accounts by stretching out distributions over the longest period possible. If the participant needs the funds, however, he can withdraw more than the required minimum distribution at any time.

Minimum distributions from IRAs, SEPs, SIMPLE IRAs, and qualified plans must begin by April 1 following the year in which the participant reaches age 701/2, referred to as the "required beginning date" (RBD).2 Under certain circumstances, if a participant is still working for an employer sponsoring a qualified plan (profit sharing, money purchase, and 401(k) plans), minimum distributions are not required at age 701/2. Instead, the participant can delay minimum distributions until April 1 following the year she retires, provided the participant owns no more than 5 percent of the business. This exception applies only to the qualified plan the employer sponsors, not IRAs or accounts held in qualified plans of former employers.

Although the participant can delay the first required minimum distribution until April 1 of the year following age 701/2, he must receive all subsequent minimum distributions by December 31 of each year.3 Delaying the first minimum distribution will require the participant to receive two minimum distributions the first year, thus increasing his taxable income for that year.

Prior to reaching RBD, the two most important decisions for the participant are determining the proper "designated beneficiary" and the "minimum distribution method" for each QP/IRA account. These decisions affect minimum distributions to the participant and distributions to the beneficiaries after the participant's death.

The participant determines minimum distributions by dividing the QP/IRA account balance as of December 31 of the preceding year4 by either the single life expectancy of the participant, or the joint life expectancy of the participant and a "designated beneficiary."5 A "designated beneficiary" must be a natural person (or a "qualifying trust") identified on the beneficiary designation form at RBD.6 Only a designated beneficiary's life expectancy may be used to calculate minimum distributions under a joint life expectancy minimum distribution method.

The Designated Beneficiary

Life expectancy tables are found in the Treasury Regulations.7 The joint life expectancy of the participant and a designated beneficiary will be longer than the single life expectancy of the participant. Thus, using the participant's single life expectancy always requires a higher minimum distribution each year than using the joint life expectancy of the participant and a designated beneficiary.

If the participant chooses a very young non-spouse beneficiary, the actual joint life expectancy would be very long. Under the general rules, this result would produce very small minimum distributions. To prevent this result, the Proposed Treasury Regulations require the participant to use the Minimum Distribution Incidental Benefit (MDIB) tables to calculate joint life expectancy if a non-spouse beneficiary is more than ten years younger than the participant.8 The MDIB tables affect lifetime minimum distributions to the participant only and not minimum distributions to the beneficiary, which will be discussed later.

If the participant does not select a designated beneficiary, the QP/IRA plan may name a default beneficiary, who may not be the intended beneficiary.9 The real problem, however, is if the participant is considered to have no designated beneficiary, because the participant can use only her single life expectancy to calculate minimum distributions.

Spouse as Beneficiary. Naming the spouse as beneficiary at RBD has a distinct advantage. During the participant's lifetime, actual joint life expectancy of the participant and the spouse will be used to calculate minimum distributions. In addition, after the participant's death, only a surviving spouse beneficiary may rollover the QP/IRA account(s) into an IRA in the spouse's name.10 Thereafter, the spouse can name a new designated beneficiary of the IRA. From that point on, the IRA is treated as the surviving spouse's IRA for minimum distribution purposes. The spouse has this option, regardless of the age of the participant or spouse at the participant's death.

Non-Spouse as Beneficiary. Although the beneficiary's assumed life expectancy under the MDIB tables is shorter than his actual life expectancy, minimum distributions during the participant's lifetime will be lower than if the participant has no designated beneficiary at RBD. After the participant's death, the non-spouse beneficiary may use her actual remaining life expectancy to "stretch out" distributions.11 If the non-spouse designated beneficiary is not more than ten years younger than the participant, the actual joint life expectancy of the participant and the non-spouse designated beneficiary may be used to calculate minimum distributions during the participant's lifetime and after the participant's death.

Multiple Beneficiaries. If the participant names multiple individual beneficiaries at RBD, the joint life expectancy of the participant and the oldest beneficiary is used to calculate minimum distributions during the participant's lifetime (subject to MDIB rules), and for the beneficiaries after the participant's death.12 Selecting a non-natural person (i.e., estate, non- qualifying trust, or charity) as one of the multiple beneficiaries, however, is equivalent to having no designated beneficiary.13

Estate or Trust as Beneficiary. Naming the participant's estate, or a trust (except qualifying trusts) as the beneficiary of the QP/IRA account is the same as having no designated beneficiary for minimum distribution purposes.14 Only the participant's single life expectancy can be used to calculate minimum distributions, resulting in higher minimum distributions to the participant than if she used a joint life expectancy.

Charity as Beneficiary. Naming a charity as the beneficiary of a QP/IRA account provides significant estate and income tax benefits. Generally, any QP/IRA funds passing directly to a charity will be deductible for estate tax purposes. Also, distribution of QP/IRA funds directly to a charitable organization as beneficiary generally avoids income taxes. Naming a charity as the beneficiary at RBD, however, is the equivalent of having no designated beneficiary for minimum distribution purposes, resulting in higher minimum distributions to the participant. From a planning perspective, this may not be a desirable result. As an alternative, the participant can name a designated beneficiary as primary beneficiary and the charity as contingent beneficiary. In this case, the joint life expectancy of the participant and the designated beneficiary (subject to the MDIB rules) will be used to calculate minimum distributions during the participant's lifetime. Upon the participant's death, the designated beneficiary can disclaim the QP/IRA account so the proceeds pass to the charity as contingent beneficiary.

"Qualifying Trust" as Beneficiary. A trust named as beneficiary is treated as a designated beneficiary for minimum distributions purposes, if it meets the following requirements: (1) the trust is irrevocable at RBD, or is a revocable trust that will become irrevocable at participant's death, according to the trust's terms; (2) the beneficiaries of the trust are identifiable; (3) the trust is valid under state law (or would be except that it has no corpus); and (4) the participant provides the plan administrator with the trust document (and any amendments) or a list of the beneficiaries of the trust (including contingent beneficiaries) with each beneficiary's proportionate share (and any conditions required to be met) and a certification that the list is correct and complete, and the other requirements (stated above) are satisfied.15 If these requirements are met, the joint life expectancy of the participant and the trust's beneficiary (or oldest beneficiary), subject to the MDIB rules, will be used to calculate minimum distributions during the participant's lifetime, and after the participant's death.

The participant can change who has the right to receive the QP/IRA account after death at any time. If the participant changes the beneficiary after RBD, however, calculation of minimum distributions will not change unless the new beneficiary is older or the new beneficiary is the participant's estate, a non-qualifying trust, or a charity.16 If the new beneficiary is older than the beneficiary named at RBD, the participant must use the joint life expectancy of the participant and the new beneficiary to calculate future minimum distributions during the participant's lifetime (unless the MDIB tables still apply) and after the participant's death.

Minimum Distribution Methods

If the new beneficiary is the participant's estate, a non-qualifying trust, or a charity, the participant can use only her single life expectancy for calculating future minimum distributions.

Minimum distribution methods have two components: (1) single versus joint life expectancy (discussed above), and (2) recalculation of life expectancy versus non-recalculation/term certain life expectancy. The selection of a minimum distribution method at RBD is irrevocable and cannot be made without first determining the choices available under the particular QP/IRA plan, because the plan may not offer all of the available methods.

Non-Recalculation/Term Certain. Life expectancy is determined and fixed for a term certain at RBD, and thereafter, is reduced by one each year.17 Because life expectancy is fixed for a term certain, death will have no effect on calculation of minimum distributions in subsequent years. The participant must use the non-recalculation/term certain method for a non-spouse designated beneficiary's life expectancy.

Recalculation. Life expectancy will be redetermined every year under the life expectancy tables based on current age.18 The participant may elect to recalculate his life expectancy, and/or the life expectancy of a spouse designated beneficiary.19 Minimum distributions generally will be lower under a recalculation method, because life expectancy is reduced by less than one each year. Recalculation of life expectancy is applied as the default method.

Death will have an effect on the calculation of minimum distributions, because the decedent's life expectancy will be zero the year following death.20 For example, if the spouse beneficiary dies first and her life expectancy is being recalculated, the participant must revert to using his single life expectancy to calculate minimum distributions. If the participant also is recalculating life expectancy, a lump sum must be distributed at his death.

Case Study: Fred's IRA

How minimum distribution methods affect lifetime distributions to the participant and beneficiary distribution options after the participant's death perhaps is best explained by examples. The following facts will be used for all examples: Fred is the IRA participant who has reached RBD and will calculate life expectancy at age 70. His spouse, Bonnie, is 67. They have two children—Danny is 46, and Betsy is 36. They also have two grandchildren—Emily is 22, and Gus is 16. Fred's brother, Fritz, is 61.

Joint Life Recalculation for Participant and Spouse Beneficiary (Double Recalculation). This is the default method when a spouse is the designated beneficiary at RBD. It produces the smallest minimum distributions during the participant's lifetime, provided the spouse does not die first. Using Fred and Bonnie's joint life expectancy of 22 years at RBD produces lower minimum distributions than using Fred's single life expectancy of 16 years. If Bonnie dies before Fred, however, minimum distributions after Bonnie's death will be much higher, because Fred must use his single life expectancy for future minimum distributions.

For example, assume Bonnie dies four years after Fred's RBD. In the year following Bonnie's death, Fred must use his remaining single life expectancy of 13.2 years to calculate minimum distributions, instead of their joint life expectancy of 18.6 years. Bonnie's death also creates a disastrous effect on the beneficiary's options at Fred's death. If Fred names his children as contingent beneficiaries and Bonnie dies first, the children (as contingent beneficiaries) must receive a lump sum distribution of the entire QP/IRA account at Fred's death. If Fred dies first, Bonnie (as spouse beneficiary) can rollover the QP/IRA account into her own IRA account. Thereafter, she can name a new beneficiary and choose a new minimum distribution method when she turns 701/2 ("super stretch out IRA").

Joint Life Non-Recalculation/Term Certain for Participant and Spouse Beneficiary (Double Term Certain). This method fixes the joint life expectancy of the participant and the spouse designated beneficiary for a term certain at RBD. In calculating minimum distributions, Fred and Bonnie's fixed joint life expectancy at RBD is 22 years, the second year it will be 21, the third year 20, etc. If Bonnie dies first, calculation of Fred's future minimum distributions remains the same.

For example, if Bonnie dies two years after Fred's RBD, the year following Bonnie's death, his minimum distribution will be calculated using a 19-year joint life expectancy. Assuming Fred names his children as contingent beneficiaries, and Fred dies the year after Bonnie (three years after RBD), his children can stretch out distributions for 18 years. If Fred dies first, Bonnie (as spouse beneficiary), can rollover the QP/IRA account to her own IRA, select a new designated beneficiary, and a new minimum distribution method at her RBD ("super stretch out IRA").

Other Options for Participant and Spouse Designated Beneficiary. When the spouse is the designated beneficiary, the participant can choose the recalculation method for one life expectancy and the non-recalculation/term certain method for the other.21 This can be advantageous under limited circumstances.

Joint Life Non-Recalculation/Term Certain for the Participant and Non-Spouse Beneficiary (Double Term Certain). During the participant's lifetime, he must use the MDIB tables to calculate joint life expectancy, if the non-spouse beneficiary is more than ten years younger than the participant. Therefore, whether the participant's life expectancy is recalculated or a fixed-term certain is irrelevant. For example, if Fred names Danny as designated beneficiary at RBD, the MDIB tables provide for a joint life expectancy of 26.2 years, regardless of whether Fred chooses recalculation or term certain for his life expectancy. In addition, minimum distributions during Fred's lifetime will be less than if Bonnie is the designated beneficiary at RBD because Bonnie is less than ten years younger than Fred.

After the participant's death, the double term certain method is advantageous to Danny, as beneficiary. As discussed above, Fred must use the MDIB tables to calculate minimum distributions during his lifetime, which provide for a joint life expectancy of 26.2 years. After Fred's death, however, Danny can use their remaining actual fixed joint life expectancy to calculate minimum distributions. The actual fixed joint life expectancy of Fred and Danny at RBD is 37.4 years. If Fred dies four years after RBD, the following year Danny can stretch out distributions over 32.4 years.

If Fred chooses to recalculate his life expectancy, Danny can use only his remaining actual fixed single life expectancy (36.8 years at RBD) after Fred's death. For example, if Fred dies four years after RBD, the following year Danny can stretch out distributions for 31.8 years only. Choosing the recalculation method for the participant's life expectancy may lower his lifetime minimum distributions, if the non-spouse beneficiary is less than ten years younger than the participant.

As discussed above, if the participant names multiple individual beneficiaries (or a qualifying trust with multiple beneficiaries), the joint life expectancy of the participant and the oldest beneficiary must be used to calculate minimum distributions during the participant's lifetime (limited by the MDIB rules) and after the participant's death. For example, if Fred has only one IRA account, and names his brother, his children, and his grandchildren as designated beneficiaries, he must use the joint life expectancy of Fred and Fritz only to calculate minimum distributions. Because the fixed joint life expectancy of Fred and Fritz at RBD is 25.6 years, if Fred dies four years after RBD, the year after his death the beneficiaries can stretch out distributions over only 20.6 years.

Separating the QP/IRA account into five separate IRA accounts, and naming each individual as the sole beneficiary of an IRA account, creates a dramatic difference for the younger beneficiaries. If Fred dies four years after RBD, the year after his death, Danny can stretch out distributions over 32.4 years, Betsy over 41.6 years, Emily over 54.9 years, and Gus over 60.8 years. Maintaining five separate IRA accounts may be an administrative hassle for Fred, but his younger beneficiaries can stretch out distributions over a much longer period of time. The increased tax deferral opportunities for his younger beneficiaries may outweigh the added inconvenience.

Single Life Expectancy Methods. Because the participant can withdraw more than the required minimum distribution at any time, single life expectancy methods provide no advantages. If the designated beneficiary predeceases the participant, she will be treated as having no designated beneficiary and must use (or revert to, if after RBD) a single life expectancy method to calculate minimum distributions. Naming a contingent beneficiary is always advisable to avoid this result.

For example, assume Bonnie is the beneficiary and she dies before Fred's RBD. If Fred has no contingent beneficiary and fails to name a new designated beneficiary at RBD, he must use his single life expectancy to calculate minimum distributions. If Fred chooses to recalculate life expectancy (or if it is applied by default), the beneficiary must receive a lump sum distribution the year after Fred's death. Under the non-recalculation/term certain method, Fred's fixed single life expectancy at RBD is 16 years. Assuming Fred dies four years after RBD, the following year the beneficiary (even Fred's estate) can stretch out distributions for 11 years, his remaining fixed single life expectancy.

Beneficiary Options if Participant Dies Prior to Age 701/2

If the participant dies before RBD, a surviving spouse beneficiary can make a tax-deferred rollover to the surviving spouse's own IRA. Thereafter, the surviving spouse is treated in every manner as the participant of the IRA. Consequently, if the surviving spouse is not 59_, distributions will be subject to the 10 percent premature penalty, unless an exception applies.22 As an alternative, the surviving spouse can leave the QP/IRA account in the name of the deceased participant and receive distributions without the 10 percent premature distribution penalty, even if the surviving spouse is not over age 591/2.23 In addition, the spouse can postpone minimum distributions until the participant would have been 701/2. At that time, the surviving spouse must receive minimum distributions based on the surviving spouse's life expectancy.

A non-spouse designated beneficiary (i.e., children, grandchildren, or qualifying trust) cannot treat the IRA as his own. Only two distribution options are available: (1) the QP/IRA account must be completely distributed to the beneficiary within five years of the participant's death; or (2) the beneficiary receives minimum distributions over his life expectancy (or the life expectancy of the oldest beneficiary) beginning no later than December 31 of the calendar year following the death of the participant.24 The beneficiary always can take more than the required minimum distribution. An estate or non-qualifying trust must deplete the QP/IRA account completely within five years of the participant's death. If the participant dies after age 701/2 but before the RBD, the participant is treated as dying before the RBD for minimum distribution purposes.25

Estate Tax Issues

Roth IRA

Notes

  1. I.R.C. § 4974.
  2. I.R.C. § 401(a)(9)(C).
  3. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A F-1(c).
  4. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A F-5(a).
  5. I.R.C. § 401(a)(9)(A)(ii); and Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A F-1.
  6. Prop. Treas. Reg. §§ 1.401(a)(9)-1, Q&A D-1, D-2, & D-2A.
  7. Prop. Treas. Reg. §§ 1.401(a)(9)-1, Q&A E-3 & 4; and Tables V and VI of Treas. Reg. §§ 1.729.
  8. Prop. Treas. Reg. §§ 1.401(a)(9)-2, Q-4 & Q-5(b).
  9. Prop. Treas. Reg. §§ 1.401(a)(9)-1, Q&A D-1 & D-2.
  10. Prop. Treas. Reg. §§ 1.408-8, Q&A A-4 & A-6.
  11. Prop. Treas. Reg. § 1.401(a)(9)-2, Q-3.
  12. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-5.
  13. Id.
  14. Prop. Treas. Reg. §§ 1.401(a)(9)-1, Q&A D-2A & D-5.
  15. Prop. Treas. Reg. §§ 1.401(a)(9)-1, Q&A D-5, D-6, & D-7.
  16. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-5.
  17. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A F-1(d).
  18. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-8.
  19. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-6.
  20. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-8.
  21. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A E-7(b).
  22. I.R.C. §§ 72(t)(1) & (2).
  23. I.R.C. § 401(a)(9)(B)(iv); Prop. Treas. Reg. §§ 1.401(a)(9)-1, Q&A C-1 & C-3; and Prop. Treas. Reg. § 1.408-8, A-1.
  24. I.R.C. §§ 401(a)(9)(B)(ii) & (iii).
  25. Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A B-5(a).

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