Guest Article

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Caution: This article does not reflect the reproposed IRS regulations (click) published in the Federal Register on January 17, 2001.

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Minimum Distribution Requirements

(IRAs and Qualified Defined Contribution Plans)

An Analysis by Raymond J. Rogers
President, Distribution Strategies, Inc.

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Beginning no later than April 1 of the calendar year following the attainment of age 70-1/2 (or, in certain cases, a later actual retirement date), strict rules need to be observed when planning distributions from conventional (i.e., other than Roth-style) IRAs and qualified retirement plans. If permitted by the terms of these plans, IRS requirements may be met by amortizing payouts over:

• a fixed number of years; or,
• in the case of the owner of the account and/or a spouse, a variable period of time.

In either case, the intent of the rules is to have accumulated funds be systematically depleted over the life expectancy of the individual who created the account and, if one is named, a designated beneficiary. With careful planning, however, it is possible to extend the potential life of the plan for many additional years.

Combinations of the two basic distribution methods are possible and, in many cases, desirable. Decisions regarding the method(s) to be used to calculate minimum payments and the beneficiary(ies) designated to receive any account balance that remains after the owner's death are often interrelated. Both of these decisions need to be made and communicated to plan administrators prior to the April 1 date by which payments must begin. The IRS rules govern only the minimum amounts that need to be distributed. Larger withdrawals may be made at any time.

Setting Objectives

Investment income earned on assets accumulated in conventional Individual Retirement Accounts and employer-sponsored qualified retirement plans is sheltered from income tax until funds are withdrawn. This deferral of tax permits investment earnings to accumulate on money previously contributed to the plans as well as on all prior investment earnings on those contributions. Pretax compounding of investment return helps these assets grow at a faster rate, and last longer, than conventional savings where a portion of each year's investment earnings is siphoned-off in tax. It is a compelling reason for retirees and their survivors to tap any available taxable investments to meet income needs before drawing down account balances in IRAs and qualified defined contribution plans. The IRS, however, places limits on how long these valuable tax shelters can be maintained. It also imposes severe penalties if its requirements are not met.

The principal objectives (in the order of their priority) in arranging the distribution of balances accumulated in IRAs and qualified defined contribution plans should be to:

First: Assure that IRS minimum distribution requirements are met and penalty taxes applicable to premature distributions are avoided.

Second: Withdraw sufficient investment income and principal to meet income replacement needs taking into account the affect inflation is likely to have on the purchasing power of future withdrawals.

Third: Maintain the tax deferred status of investment income for the benefit of heirs, recognizing that qualified plan benefits and IRAs are includable in the decedent's taxable estate unless they qualify for the marital deduction or are sheltered by the unified estate and gift tax credit. (This credit, which currently exempts the first $625,000 in the estate from tax, is scheduled to increase to $1,000,000 between now and 2006.)

In a growing number of cases, as account balances become large enough to produce meaningful lifetime retirement income, retirees need to consider distribution planning from two, possibly quite different, perspectives. By virtue of the IRS requirements applicable to qualified plans and conventional IRAs they must file a formal plan that irrevocably governs how compliance with the minimum distribution rules will be measured. In another, equally important, plan the individual needs to carefully consider how available resources will, in fact, be allocated to meet future inflation adjusted income requirements and estate planning objectives.

In many instances, year-by-year income replacement needs may prove to be such that actual distributions must exceed the minimums required by the IRS. That potential, even likely, outcome should not obscure the value of a properly designed compliance plan. It merely means different purposes are being served by the two plans. The compliance plan should compel only minimum distributions, thus preserving the availability of the tax shelter. The well designed conventional IRA or qualified plan will then permit actual distributions, which are equal to or greater than the required minimums, to occur as needed. Unfortunately, while IRS rules permit considerable flexibility in constructing the compliance plan, many qualified defined contribution programs (and a significant number of conventional IRAs) severely restrict a retiree's ability to achieve the intended objectives of either plan.

IRS Rules

IRS minimum distribution rules are presented in question and answer format in extensive regulations issued under Internal Revenue Code sections 401(a)(9), 408(a)(6) and 408(b)(3). The regulations (issued in proposed form in 1987) may be relied upon until final ones are released. The IRS rules are designed to prevent unreasonable deferral of tax on assets accumulated in IRAs and qualified plans. Roth-style IRAs (where income tax is paid up-front on contributions, or amount rolled over, to the plan) are exempt from these distribution requirements during the owner's lifetime (as well as the lifetime of the owner's spouse when the spouse is the sole beneficiary).

What the IRS terms the required beginning date is a critical point in a retiree's lifetime. This is generally April 1 of the calendar year following the attainment of age 70-1/2. However, except for 5% or more owner employees, when actual retirement is deferred beyond age 70-1/2, the required beginning date for distributions from an employer's qualified plan (but not a conventional IRA) is also deferred until April 1 of the calendar year following the employee's actual retirement. Distributions from qualified plans and conventional IRAs must commence by the required beginning date and different minimum distribution rules apply depending upon whether death occurs before, or on or after, this date.

Prior to the Required Beginning Date

At the death of the owner of an IRA or a participant in a qualified defined contribution plan (in either case, generally referred to as an "owner" in this discussion) prior to:

• the required beginning date in a qualified plan or a conventional IRA, or
• distribution of the entire balance in a Roth IRA,

a designated beneficiary may elect to spread payments over a fixed period of years starting with the calendar year following the owner's death and calculated to end within the beneficiary's expected lifetime. This basis of amortizing the payout of the account balance is typically referred to as the term certain method. It is important note there is no requirement for any distributions to be made during the lifetime of the owner's widow or widower when the spouse is the sole beneficiary of a Roth IRA.

When the designated beneficiary of a qualified plan or a conventional IRA is the owner's spouse, the widow or widower may elect to defer the start of payments until the end of the calendar year in which the owner would have reached age 70-1/2. Alternatively, the surviving spouse may postpone distributions until as late as his or her own required beginning date by: (i) treating the deceased owner's IRA as his or her own (ii) or rolling all or a portion of an account balance in the owner's IRA or qualified plan over to a new IRA. As is the case with any IRA, however, withdrawals by the spouse prior to age 59 1/2 may then be subject to a 10% penalty tax (while distributions from the owner's qualified plan or IRA on account of the owner's death would be free of this additional tax.) When periodic distributions must commence to the spouse, the factors used to calculate required minimum payments may be determined once based on the surviving spouse's life expectancy (the term certain method) or they may be recalculated each year based on current life expectancy (the recalculation method).

Except as noted in the case of the widow or widower of the owner, annual payments of minimum distributions to the beneficiary must begin by the end of calendar year following the year of the owner's death. If payments are delayed beyond that time or there was no designated beneficiary, the entire account balance must be distributed by the end of the fifth calendar year following the year of the owner's death. The IRS permits plans to limit the term of all payments after the owner's death and/or restrict the elections permitted by owners and beneficiaries. Many qualified plans (and some IRAs) contain these further limitations.

On and After the Required Beginning Date

Within the 15-month period ending on the required beginning date and by the end of each calendar year thereafter, distributions must be made to owners of conventional IRAs and participants in qualified plans. Note that Roth IRAs are exempt for this requirement during the owner's (and, where the spouse is the sole beneficiary, the spouse's) lifetime. The amount of each required minimum distribution may be calculated by applying either the term certain or recalculation method to determine the owner's life expectancy. If the owner has a designated beneficiary (as opposed, for example, the estate or a trust), the beneficiary's life expectancy may also be used to calculate the maximum period over which payments may be amortized. Under the term certain approach this calculation is performed only once based on the attained ages of the owner and beneficiary as of their respective birthdays in the calendar year preceding the required beginning date. Alternatively, when the joint annuitant is the owner's spouse, the recalculation method may also be used to determine life expectancy at his or her attained age each year.

It is important to check the plan documents or otherwise to contact the administrator(s) of IRAs and/or qualified defined contribution plans to make sure the term certain and recalculation methods are permitted for determining life expectancy of both the participant and the spouse. The IRS permits plans to limit the available method to only the term certain approach and/or limit the period of time over which distributions may be made following the death of the owner. Many qualified plans, as well as some IRAs, provide substantially less flexibility than is allowed by the IRS. If the plan document for a qualified plan or a conventional IRA does not specify: (a) which method is to apply in the event the owner fails to make an election, or (b) that only the term certain method is to be used, the IRS automatically requires the recalculation method to be used for both the owner and spouse.

Failure to comply with IRS minimum requirements results in a 50% excise tax -- on top of normal income tax rates -- on funds that should have been withdrawn based on the IRS rules. The owner of the account or surviving beneficiary may, of course, always withdraw more than the minimum required by the IRS.

Evaluating the Methods

Assuming the plan permits a choice, the decision regarding which method or combination of methods to use should be carefully considered. Elections of distribution methods and beneficiary designations must be recorded on or before the required beginning date. In the case of qualified plans and conventional IRAs, subsequent designation of a new beneficiary with a shorter life expectancy will result in larger required payouts (unless the term certain method is being used and the change is to a contingent beneficiary upon the death of the original beneficiary). However, later appointment of a beneficiary with a longer life expectancy will not reduce the amount of required distributions. The same distribution method does not have to apply to all of an owner's plans. When multiple beneficiaries are named, the life expectancy of the oldest beneficiary applies to all beneficiaries unless the designations apply to different plans or to separate accounts within a single plan.

The following table provides examples of the factors (called "expected return multiples") used by the IRS to estimate life expectancy:

	Average Life Expectancy (Years)
Owner's	No	Age of Beneficiary
Age	Beneficiary	50	60	62	65	67	70	72	75	77	80
70	16.0	34.0	26.2	24.9	23.1	22.0	20.6	19.8	18.8	18.3	17.6
71	15.3	33.9	26.0	24.7	22.8	21.7	20.2	19.4	18.3	17.7	17.0
72	14.6	33.8	25.8	24.4	22.5	21.3	19.8	18.9	17.8	17.2	16.4
73	13.9	33.7	25.6	24.2	22.2	21.0	19.4	18.5	17.3	16.7	15.9
74	13.2	33.6	25.5	24.0	22.0	20.8	19.1	18.2	16.9	16.2	15.4
75	12.5	33.6	25.3	23.8	21.8	20.5	18.8	17.8	16.5	15.8	14.9
76	11.9	33.5	25.2	23.7	21.6	20.3	18.5	17.5	16.1	15.4	14.4
77	11.2	33.5	25.1	23.6	21.4	20.1	18.3	17.2	15.8	15.0	14.0
78	10.6	33.4	25.0	23.4	21.2	19.9	18.0	16.9	15.4	14.6	13.5
79	10.0	33.4	24.9	23.3	21.1	19.7	17.8	16.7	15.1	14.3	13.2
80	9.5	33.4	24.8	23.2	21.0	19.5	17.6	16.4	14.9	14.0	12.8

If the beneficiary is not the spouse, the difference in age used to figure required minimum distributions prior to the owner's death must be limited to 10 years (i.e., in the shaded area of the chart). Yet, when the beneficiary is actually more than 10 years younger, required minimum distributions can be redetermined for payments due in years following the owner's death. (After the owner's death, the beneficiary's life expectancy is reestablished by using the term certain period -- reduced by the number of years elapsed between the first distribution year and the year of the owner's death -- that would have applied in the absence of the ten year limitation.)

Term Certain Method

With the term certain approach, a fixed number of annual payments (limited so as to not extend beyond the life expectancy of the owner and, if applicable, the joint annuitant) is established once based on age as of the birthday(s) in the year preceding the required beginning date. According to the IRS tables, an owner who is age 70 as of the birthday in that year has an average remaining lifetime of 16 years (refer to the column headed "No Beneficiary" in the preceding table). In this case, since there is no designated beneficiary, the fixed period of over which minimum payments are amortized under the term certain method is 16 years. The portion of the account that must, at a minimum, be paid out to the 70 year old owner on account of the first distribution year is thus 1 ÷ 16 (or 6.25% of the account balance as of the December 31 preceding the attainment of age 70-1/2). The minimum distribution for each succeeding year is determined by successively shortening the fixed period of payments (the denominator of the fraction) by "1". In this example, the minimum amount that must be distributed the second year (at age 71) is thus 1 ÷ 15 or 6.67%. At age 72, it is 1 ÷ 14 (7.14%). In the sixteenth year (at age 85), the minimum is 1 ÷ 1, or 100%, which exhausts the account. Similarly, if this owner had designated an individual age 67 as the beneficiary, the required minimum payout on account of the first distribution year would be 1 ÷ 22 (or 4.54% of the account balance).

Calculating minimum distribution amounts using the term certain approach is the simplest way to assure compliance with the IRS rules. Use of this method also represents a relatively conservative approach to measuring the needs of the living since the number of years over which payments may be amortized is quite liberal based on current mortality. The duration of payments is thus likely to exceed the length of time many individuals will depend on accumulated assets for income. Because the factors do not (as the result of federal restrictions applicable to qualified plans which prohibit gender-based discrimination) recognize that the average male's life expectancy is shorter than the average female's, the tables are particularly conservative in their projection of life expectancy for males.

Perhaps the greatest appeal of the term certain approach lies in the fact that the duration of payments is fixed at the outset. The amortization period thus survives the death of the owner and/or the joint annuitant. In other words, if withdrawals are originally calculated to be permitted over a 20-year period (based on the attained ages of the owner and joint annuitant in the calendar year preceding the required beginning date), payments may continue for the remainder of that period, even if one -- or both -- of the individuals die during the first distribution year.

Recalculation Method

Unlike the term certain method which sets the payout period based on a single snapshot of life expectancy, the recalculation method recalculates life expectancy each year. The recalculation method is thus more precise. It is also a better reflection of the real world since life expectancy, in fact, decreases by less than a year for each year that we age. [Note, for example, in the "No Beneficiary" column of the preceding table, that life expectancy generally declines by from one-half to three-quarters of a year for each year of advance in age.]

For the individual age 70 in the preceding example who has not named a designated beneficiary, both the term certain and recalculation distribution methods start by requiring at least 1/16 (6.25%) of the account balance to be paid out on account of the first distribution year. In the second year, however, recalculation of life expectancy calls for a minimum distribution of 1/15.3 (6.54%) rather than the 1/15 (6.67%) required by the term certain method. Although this difference is initially modest, it grows substantially with the passage of time. By age 80, the required minimum distribution calculated under the recalculation method is 1/9.5 (10.53%) compared with 1/6 (16.67%) using the term certain approach. And, while the term certain method calls for the payout of any remaining balance at age 85 (when the fraction is 1/1 for this individual), the recalculation method keeps on estimating some future life expectancy -- and thus permitting minimum distributions -- until death actually occurs.

The recalculation method can overcome a potential disadvantage of the term certain approach. By opting to recalculate life expectancy, the owner and/or an economically dependent designated beneficiary avoid(s) the risk that the account balance will be depleted by the operation of the minimum distribution rules while there is still a continuing need for income. However, the recalculation method may impose a significant disadvantage in the event of an early death since life expectancy for that individual then falls to zero. Use of the method can thus serve to accelerate the rate of required distributions, even to the extent of requiring payout of the entire account balance by the end of the year following death (e.g., if there is no designated beneficiary).

It is important to note that use of the recalculation method for the spouse always commits the owner of the account to increased payments in the event the spouse dies first. Yet, the same result can apparently be avoided when the owner is the first to die.

Hybrid Methods

While the recalculation method can only be used to determine life expectancy for the owner of the account or a spouse, the term certain method be used for any individual. It is theoretically possible (but may not be permitted by the terms of a particular plan) to choose any of the combinations of methods shown in the following table:
 

ALLOWABLE DISTRIBUTION METHODS

Account Owner	Designated Beneficiary
	Spouse	Other than Spouse
Term Certain	Term Certain	Term Certain
Term Certain	Recalculation	Term Certain
Recalculation	Recalculation	Term Certain
Recalculation	Term Certain	Term Certain

Married couples should carefully consider the advantages gained by combining distribution methods. It is often desirable to apply the recalculation method to the owner, particularly if the owner enjoys relatively good health and has a family history of longevity. With this choice, lifetime payments for the individual who created the account can be assured. When the choice of the recalculation method for the owner is combined with the use of the term certain method for the spouse, the life expectancy originally determined for the spouse remains in the calculation of required minimum distributions until the end of the term certain period -- irrespective of the spouse's actual longevity. On the other hand, if the spouse is the designated beneficiary and the owner is the first to die, the use of the recalculation method for the owner's life doesn't have to result in accelerated distributions. This seemingly incongruous result is due to the unique ability of surviving spouse to elect to:

• treat the deceased's conventional IRA as his or her own (or roll the deceased's IRA over to a new IRA owned by the spouse) or,
• if permitted by the terms of the plan, roll an account balance in a qualified plan over to an IRA owned by the spouse.

The widow or widower who rolls over, or otherwise assumes ownership of the decedent's account, is then able to designate a new beneficiary. Thus, for example, the widow or widower may name a child (or grandchild) as the designated beneficiary. An age differential of ten years can be used to initially determine their joint life expectancy. At the subsequent death of the last surviving parent (or grandparent), required minimum distributions for any balance in the account can be redetermined based on the remainder of the term certain period that would have applied in the absence of the 10-year limitation on the difference in age.

The first year's distribution must be completed within the 15-month period ending on the required beginning date. The expected return multiple for the distribution method selected is divided into the account balance on the last valuation date (usually December 31) of the plan year preceding the calendar year the owner attains age 70-1/2. Each subsequent year's distribution is based on the account balance on the last valuation date of the prior year and the corresponding distribution must be completed by December 31 of the current distribution year.

Naturally, if the first year's distribution is deferred beyond December 31 of the year preceding the required beginning date, there will be two distributions in the second tax year. Doubling up in this manner complicates the calculation of the distribution for the second year and should generally be avoided, particularly if it will cause some income to be taxed at a higher marginal rate.

The minimum distribution requirements are not cumulative. In other words, a larger than required distribution in one year (or any distribution in a year when none is required -- i.e., prior to required beginning date) does not represent an offset to the required distribution in a subsequent year. (It does, of course, reduce the account balance used to compute subsequent required distributions.)

Additional Considerations

Married couples naturally assume it is appropriate for the spouse to be designated the beneficiary. While that may be a good idea, there are situations where it makes economic sense to focus directly on the longer term preservation of the tax shelter by naming children and/or grandchildren the beneficiaries. The suitability of this approach generally depends on: the health of the owner's spouse; the adequacy of income available to the spouse from other sources; and estate tax considerations, especially qualification of plan assets for the unified estate and gift tax credit.

There are also times when it may be desirable to name a trust, rather than the spouse, child(ren), or other individual, beneficiary of an IRA or qualified plan. For example, the owner of an account may wish to retain control over the disposition of assets following the death of a surviving spouse (calling for the use of a "qualified terminable interest property", or "Q-TIP," trust). Or assets, other than IRA and/or qualified plan proceeds, may be insufficient to take full advantage of the unified gift and estate tax credit available to each decedent (in which case a "credit shelter" trust may be used to channel income to a spouse while reducing estate taxes at his or her subsequent death). A trust is also called for when the beneficiary is a minor or incompetent.

Since a trust does not have a life expectancy of its own, it can't be recognized as the designated beneficiary for the purposes of calculating minimum distributions under either the term certain or recalculation methods. Yet, if the following requirements are met, the life expectancy of the beneficiary of the trust may still be used to calculate the "expected return multiple:" (1) the trust is valid (except for the fact that it may have no assets) under state law, (2) the beneficiary of the trust is an identifiable individual, even if not specifically named, (3) the trust is irrevocable or becomes irrevocable by its terms as of the death of the owner, and (4) a copy of the trust document (and any amendments) or certified listing of all beneficiaries is furnished to the plan administrator.

It is important to note that when the trust is the beneficiary, the spouse (who is in turn named beneficiary of the trust) forfeits the right to assume ownership of the decedent's IRA or roll the proceeds of a qualified plan over to his or her own IRA (and thus name a new beneficiary). In addition, IRS rules applicable to a "Q-TIP" trust require annual disbursements to at least equal investment income, so the spouse may be unable to defer the commencement of distributions until the decedent would have reached age 70-1/2;.

If a decision is reached to name a trust, or any individual other than the owner's spouse, as the beneficiary of proceeds from a qualified plan, the spouse must affirm his or her consent to the designation. Spousal consent to a beneficiary designation is not required in the case of an IRA (including an IRA established as part of a Simplified Employee Pension Plan).

Distributions from qualified defined benefit pension plans are also governed by IRC section 401(a)(9). Installment payments under these plans are normally in the form of annuities designed by the administrators of these plans to meet IRS requirements. Similarly, if all or a portion of the account balance is used by an IRA or qualified defined contribution plan to purchase an annuity, the insurer and plan administrator or trustee should assure that payments comply with IRS requirements.

On or before the required beginning date, a Beneficiary Designation and Minimum Distribution Method election form, such as the one included with this compliance package (or a comparable form furnished by the plan administrator), should be completed and signed copies filed with the administrators of the owner's IRA(s) and qualified defined contribution plan(s). Failure to make an affirmative election of a distribution method causes the default distribution method specified in the plan (or, if none is specified, the recalculation method) to be used to determine the ERMs for the owner and a spouse designated the beneficiary. If a trust has been appointed to receive the proceeds, a copy of the trust agreement should be furnished to the plan administrator.

Finally, since many qualified plans (and some IRAs) restrict the distribution options available to participants and their beneficiaries, it is very important to check with the plan administrator(s) to be sure the payout strategy you intend to adopt can be accommodated by the administrative provisions of the present plan(s). If the distribution objectives decided upon cannot be achieved within these plan(s), you will need to either adopt an alternative strategy or roll the account balance over to one or more IRAs that afford greater administrative flexibility. In evaluating the rollover option, it is important to consider the relative merits of the investment options made available by the plans as well as investment and administrative expenses. It may also be important to consider the degree of protection from creditors afforded by qualified plans in comparison with IRAs.

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This document is subject to copyright protection. Permission is granted to copy the document for personal, non-commercial use. Copyright 1998 by Distribution Strategies, Inc.

For further information, please contact:

Distribution Strategies, Inc.
E-mail: dsi@bigfoot.com
Phone: (203) 698-2895

(Reprinted on BenefitsLink by permission.)