Calculating IRA distributions.

The IRS has issued a 108-page proposal containing proposed regulations on retirement account minimum required distributions (MRDs), which apply to qualified plans, individual retirement plans, deferred compensation plans under Sec. 457, and Sec. 403(b) annuity contracts, custodial accounts and retirement income accounts. Under the proposed regulations, most IRA owners should find it much simpler to calculate MRDs. Although the regulations are still under review, the Service is allowing IRA owners to begin using them for 2001 MRDs.

Simplification

In response to extensive comments, the IRS substantially simplified the 1987 proposed rules for calculating MRDs, while keeping intact many of the other 1987 rules.

The new proposed regulations simplify the rules by:

* Providing an easy-to-use table for determining MRDs during an employee's life. The calculations are simple because an employee no longer needs to (1) determine his beneficiary by the employee's required beginning date (RBD), (2) decide whether to recalculate his life expectancy each year in determining MRDs and (3) satisfy a separate incidental death-benefit rule.

* Permitting the employee to calculate MRDs during his life without regard to the beneficiary's age (except when the employee can reduce the MRDs by taking into account the age of a beneficiary-spouse more than 10 years younger. than the employee).

* Permitting a change in beneficiary as late as the end of the year following the year of the employee's death, by an employee changing designated beneficiaries after the RBD, which will not increase the MRD, and one or more beneficiaries disclaiming or cashing out or both.

* Permitting the calculation (with qualifications) of post-death MRDs to take into account an employee's remaining life expectancy at the time of death, thus allowing distributions in all cases to be spread over a number of years after death.

The employee is still required to take MRD by April 1 of the year-following the year he turns age 701/2. Failure to take the MRD could result in paying a penalty equal to 50% of the amount that should have been distributed. It is critical to plan and take the appropriate distribution to avoid this penalty.

New Rule Advantages

As under the old rules, taxpayers still want distributions to be as small as possible to delay incurring taxes, which also preserves their capital's earning potential through, compounding investments. In all situations under the new rules, MRDs cannot be higher than under the old rules. Most taxpayers will fare better using the new uniform table, because the MRDs will be lower. For example, a 75-year old with an IRA worth $1 million will save thousands of dollars in taxes each year under the new rules. Under the old rules, the taxpayer used a factor of 12.5 years and was required to withdraw $80,000 from the IRA annually. However, under the new rules, a taxpayer's factor is 21.8 years. This increase in the factor has the effect of reducing the MRD to $45,872 per year. By reducing the MRD each year by almost $34,000, the taxpayer lowers the taxes on this amount each year. The money saved in taxes each year stays in the IRA and continues to grow tax-deferred.

An exception occurs when the taxpayer has a tax savings because the beneficiary is more than 10 years younger. In that case, the MRD and taxes will be the same as under the old rules. For example, if the taxpayer is married and his spouse-sole beneficiary is more than 10 years younger, the new rules do not put the taxpayer in a worse position. Even if the taxpayer is not married, but names a beneficiary more than 10 years younger, the new rules will not increase the MRD.

Under the new rules, a taxpayer is no longer required to "lock in" beneficiaries on April 1 of the year following the year he turns 701/2. Under the proposed regulations, the taxpayer can name beneficiaries any time up to his death. Generally, even after death, the designated beneficiaries can be determined up until December 31 of the year after the taxpayer's death, provided the account holder, prior to death, already named the individuals as beneficiaries. This strategy could extend the life of the tax-deferred assets. Under the old rules, many problems could occur because the taxpayer did not understand the benefits of naming a designated beneficiary by that date or that he could not reduce the MRD by naming a younger beneficiary. For example, a taxpayer can designate not only a beneficiary but a contingent one as well. This enables a beneficiary to disclaim the assets, which allows them to pass to a contingent beneficiary. If the contingent beneficiary were younger, the taxpayer might be able to take the MRDs 'based on the contingent beneficiary's life expectancy. This would allow more years of tax-deferred growth, because the MRDs would be smaller under these circumstances.

Also, if there were multiple beneficiaries on an IRA, in certain situations the account could be divided among the beneficiaries, new accounts established and each beneficiary could use his own life expectancy to determine the distributions. Under the old rules, this flexibility did not exist; the MRDs would have been based on the taxpayer's or the oldest beneficiary's age. In addition, under the new rules, if a charity were also named as one of the beneficiaries, the distribution would not be forced out of the account in a year, as it was in certain situations under the old rules. Taxpayers can now name charities as beneficiaries without changing the MRD calculation, encouraging charitable giving.

Under the new rules, a taxpayer can only receive these benefits when he names beneficiaries. An account holder has to name one or more primary beneficiaries, as well as contingent beneficiaries, to take advantage of this new flexibility. Ignoring the chance to do this not only restricts flexibility, but also creates other legal problems. The beneficiary form for an IRA is the legal form required to designate a beneficiary. If the taxpayer does not name a beneficiary, the IRA assets would pass pursuant to the terms of the underlying IRA document. In many cases, this document provides that the IRA will pass to the surviving spouse or the estate. In the latter case, the assets are subject to probate, subject to executor's fees and exposed to the claims of creditors and will contests. A taxpayer can avoid all of these problems by completing an IRA beneficiary form. With the new rules, it is easier to ensure that an individual or charity that inherits the IRA will have the opportunity to stretch the distribution period.

Most of the new IRA rules also apply to all tax-advantaged retirement funds, such as Sec. 401(k) and 403(b) plans subject to MRDs. The IRA benefits have advantages over these other retirement savings vehicles, because the new rules apply immediately to IRAs, even though they do not go into effect until 2002. Participants in non-IRA retirement plans were eligible for the benefits in 2001, if any amendments to the plans were to take effect earlier than 2002. Also, IRA beneficiaries receive the full benefit of the new rules, while the retirement plan beneficiaries may never benefit, because plans may have less generous rules about extended distributions than do IRAs.

For non-IRA funds to apply the liberal extended withdrawals, they would probably incur an increase in labor and administrative costs (due to the nightmares of dealing with extended distributions over a beneficiary's life expectancy). Because such funds do not have to follow the new rules, the possible increased labor and cost would typically deter employers from adopting them. As a result, when a fund participant leaves his employer, he should roll over his retirement plan funds into an IRA and take advantage of the new rules.

Because the new proposed rules are less complicated than the former ones, the Service can monitor and enforce them better. Under the new rules, any mistakes made in the past may be forgiven, giving taxpayers a fresh start. Investment, insurance and mutual funds companies, banks, brokers and the like will all have to calculate the MRDs for all IRAs and report them to the IRS, just as they currently do for interest, dividends and capital gains on taxable accounts. This mechanism allows the Service to monitor withdrawals. Failure to comply subjects the taxpayer to a 50% penalty.

Because baby boomers, the largest part of the population, will be eligible for retirement within the next 15 years, retirement plans might represent a major source of Federal tax revenue. As a result of the new proposed MRD rules, the Service has systems in place to calculate and enforce penalties if taxpayers do not follow the rules.

FROM DAVID LAVIN AND MYRON S. LUBELL, FLORIDA INTERNATIONAL UNIVERSITY, MIAMI, FL (NEITHER AFFILIATED WITH GRANT THORNTON LLP)