The New Final IRA Regulations - Big Benefit for the Taxpayer
Good news for taxpayers who have IRAs, 401(k) plans and other retirement plans. In almost all cases, distributions from these IRAs and plans are fully taxable as ordinary income to the recipient because they represent pre-tax money. Final regulations were recently issued by the U. S. Treasury Department for IRAs, 401(k) plans and other qualified retirement plans. These new rules give IRA participants (owners) much more flexibility in naming beneficiaries and in stretching out taxable IRA withdrawals. The new rules also allow IRA beneficiaries a longer stretch-out period for IRA withdrawals after the IRA participant dies.
An IRA participant over age 70 ½ who has been withdrawing his or her IRA already can now switch to a longer stretch-out period if he or she so wishes. The participant should now contact the custodian of the IRA or administrator of the plan to make known the wish to adopt the new rules.
Under the old IRA proposed regulations of pre-2001, an IRA participant [or 401(k) participant, employee of qualified plan, etc.] could change the designated beneficiary (DB) of his IRA after reaching his Required Beginning Date (RBD) for the start of withdrawal payments. The RBD is April 1 of the year after he reaches 70 ½. However, if the new DB was younger than the former DB, the new DB was forced to use the shorter LE for computing the Minimum Required Distributions (MRD) from the IRA after the participant died. A shorter LE means a faster forced withdrawal of taxable IRA money.
The new rules allow a new DB to use his own LE, regardless of when the IRA participant changed the designation. The new rules, in fact, say that the DB will not be determined until September 30 of the year following the participant's death (the Designation Date, or the DD). The first IRA withdrawal by the DB must be taken by December 31 of the year following the death.
The new rules also provide for updated mortality tables which reflect longer life spans. For a person who has reached his or her RBD and is now making IRA withdrawals, this person may now take advantage of the smaller MRD required by the new tables.
The new rules clarify that if there are two or more DBs, each DB has the right to claim a separate account in the decedent participant's IRA. The DB must notify the IRA custodian of his election to divide the IRA prior to the DD.
Here is an example of how these new rules coalesce to provide income tax benefits. A 74-year old IRA participant has a $200,000 IRA on July 15, 2002. His DB, Adam, is 64 years old. After the IRA participant reached his RBD in 1999, he changed his DB because Adam had become wealthy and did not need the IRA and its taxable income. The IRA participant now names his two younger nephews as DBs in equal shares. Nephew Bob is 48 years old. Nephew Chuck is 41 years old.
The IRA participant dies on July 16, 2002. Chuck and Bob elect to take separate accounts in decedent's IRA ($100,000 each). Chuck's MRD for 2003, the year after the death, is computed by using his age in 2003 (age 42) in the Single Life Expectancy mortality table. The age of 42 yields a LE of 41.7 in this table. The MRD is computed by dividing the $100,000 IRA (assume no growth) by a divisor equal to the LE of 41.7. Chuck's first MRD is $2,398.08.
His MRD for subsequent years is found by subtracting one from the original divisor. In year 2004, his MRD will be computed by dividing the IRA balance by 40.7.
If Chuck and Bob did not divide the IRA into separate accounts, the rules say Chuck must use Bob's shorter LE of 35.1 as the first year divisor. If the old IRA rules had applied, both Chuck and Bob would have to use Able's LE divisor of 21.8.
The final regs add a surprise benefit for a DB who is older than the IRA participant who dies after his RBD. In such case, the DB can elect to use the longer LE of the younger IRA participant instead of his or her own LE.
The new rules clarify that if the named DB survives the IRA participant, but dies before the DD, his successor/s in interest, regardless of age, must use the deceased DB's age to compute the MRD.
The MRD for an IRA participant who does not die is also stretched out considerably more than under the old rules in almost all cases. The new rules use a new Uniform Lifetime Table which adopt a joint life expectancy of the IRA participant and a fictional beneficiary of 10 years younger. The joint life expectancy calculation produces a longer LE than a single LE, and therefore a longer stretch-out period of the MRD.
Post-mortem planning can now be done with the IRA because of the new DD rule. A new IRA DB can not be added. But a DB can be eliminated, and a new DB substituted in his place prior to the DD. For example, a friend or spouse of the IRA participant may decide he or she does not want or need the IRA. Such person may formally disclaim the IRA, in which case the IRA would go either to the contingent DB/s named in the designation form, or if none were named to the disclaimant's heirs. Under the old rules, the substitute DB/s, probably younger, would be stuck with the disclaimant's LE as a divisor.
If one of several DBs is given a pecuniary share of an IRA, no division into separate accounts can be made. However, if that pecuniary DB is cashed out prior to the DD, the remaining non-pecuniary, fractional share DBs can then elect separate accounts.
The new rules provide some new rules for the spouse of the IRA participant, and modify rules regarding Trusts which are IRA beneficiaries. For more information on these topics, please see the update article on Favorable New IRA Distribution Rules.