Planning for individual retirement accounts.

Many taxpayers default into IRA distribution methods that prove disastrous for surviving family members.

Taxpayers throughout the United States have accumulated considerable wealth in qualified retirement plans. At retirement, they generally will take lump-sum distributions from their plans and roll them over into individual retirement accounts. Proper planning will ensure continuation of IRA benefits to family members long after the IRA owners and their beneficiaries have died.

Many taxpayers default into IRA distribution methods that initially appear worthwhile but later prove disastrous to surviving family members if both IRA owners and their beneficiaries die in their 70s. This article describes available IRA distribution options to help taxpayers and their advisers make appropriate distribution elections.

MINIMUM DISTRIBUTION RULES

IRA distributions generally are subject to the required minimum distribution rules in Internal Revenue Code section 401(a)(9). On July 27, 1987, the Internal Revenue Service issued comprehensive proposed regulations for IRA minimum distribution requirements and required minimum distribution rules from other retirement arrangements.

A taxpayer must begin to receive distributions from an IRA on or before his or her required beginning date April 1 following the calendar year in which he or she reaches age 70 1/2. For example, if George Smith, an IRA owner, was born on February 1, 1923, he will reach 70 1/2 on August 1, 1993, and must begin receiving IRA distributions by April 1, 1994. Smith may take a required minimum distribution for calendar year 1993 either during 1993 or take it no later than April 1, 1994. The calendar year in which Smith becomes 70 1/2 is called his "first distribution calendar year."

Smith is permitted to postpone the first calendar year's distribution in whole or in part until the following April 1. Tax planning will dictate whether the deferral option-which is not available for any succeeding distribution calendar years--should be used. Thus, Smith's IRA distribution for 1994 must be made by December 31, 1994.

If a taxpayer fails to receive a timely required IRA distribution, he or she is subject to an excise tax of 50% of the distribution shortfall. If Smith, for example, is required to receive a required minimum distribution for calendar year 1994 of $50,000 and only receives $30,000, the excise tax liability for 1994 is 50% of the $20,000 shortfall, or $10,000. The IRS may waive the excise tax if the taxpayer's failure to receive a required minimum distribution was due to reasonable error that the taxpayer takes steps to correct. A reasonable error might occur if a taxpayer retains a pension consultant and receives inappropriate advice. Distributions from other retirement arrangements also are subject to an excise tax.

DISTRIBUTION OPTIONS

It is important for CPAs to master some of the technical aspects of the 1987 proposed regulations regarding IRA distributions. Appropriate planning may result in substantial savings.

Many taxpayers are unaware of the distribution options they can elect to satisfy the required minimum distribution rules.

The proposed regulations under section 1.401(a)(9)-1, Q&A E-7 are extensive and may be difficult to explain to a client. However, the IRA owner must make a key decision no later than his or her required beginning date, choosing to elect a fixed number of years for IRA distributions or to elect the life-expectancy recalculation method (the IRA owner's life expectancy expands each year).

Most IRA agreements permit the taxpayer to opt in or out of the life-expectancy recalculation method. Once an election is made, it is irrevocable and applies to all subsequent years. The election should be made in writing and given to the IRA custodian no later than the IRA owner's required beginning date.

If the IRA owner is permitted to elect either the term-certain or life-expectancy recalculation methods and fails to do so, the recalculation method is the default option unless the IRA agreement provides otherwise. Although the proposed regulations use terms such as "plan" and "employee," they apply to IRAs as well. Many IRA agreements in fact provide for an automatic default into the life-expectancy recalculation method if the IRA owner fails to act by the required beginning date.

RECALCULATION METHOD

Many taxpayers are not aware of the differences in the two methods and often select the recalculation method by default. For example, assume Marion Davis, an IRA owner, is unmarried and has selected her estate as beneficiary. Further, assume Davis turns both 70 and 70 1/2 in 1993. Required minimum distributions under the proposed regulations are calculated based on the IRA owner's age on her birthday in the calendar year she attains age 70 1/2 as well as her named beneficiary's attained age in that year. (If Marion did not turn 70 1/2 until 1994, the calculations would use her age on her 1994 birthday--71.)

An IRA owner who designates an IRA beneficiary on or before the required beginning date may significantly expand the required minimum distribution period. The beneficiary rules are complex and require an in-depth analysis of the proposed regulations. A named beneficiary must be either an individual or certain irrevocable trusts. While detailed analysis of the beneficiary rules is beyond this article's scope, an estate is not considered a named beneficiary under the proposed regulations.

Davis must decide whether to elect to take required minimum distributions from her IRA over a fixed number of years or to use the recalculation method. Before making the election, Davis should examine the single life-expectancy tables in table V of Treasury regulations section 1.72-9.

Initially, most taxpayers elect the recalculation method. Naturally, the expanded period of years for taking distributions this method allows results in a reduction in the annual amount of required minimum distributions that must be taken out of the taxpayer's IRA.

CPAs should advise clients the recalculation method is worthwhile if the taxpayer is in good health, has a history of family longevity and is willing to gamble on the fact he or she will live for a substantial portion of his or her life expectancy.

I have many clients who elected the fixed-number-of-years method rather than speculate on the length of their lives. On occasion, a client who wants to take the absolute minimum distribution each calendar year will use the recalculation method because he or she is interested in paying the least amount of income taxes on an annual basis.

For Davis, the recalculation method produces the maximum deferral of IRA distributions during her lifetime. However, in the year after her death her estate must accelerate distributions and may not continue the recalculation method. Thus, the recalculation method may be devastating to the estate or its beneficiaries if Davis dies in her early 70s, since the amount of income the estate or its beneficiaries must report is accelerated.

Many CPAs are not aware of the acceleration rule in the proposed regulations, which provide that if an employee's life expectancy is recalculated annually, then at his or her death, the life expectancy is reduced to zero in the calendar year following the year of death. [See proposed regulations section 1.401(a)(9)-1, Q&A E-8.] In addition, the proposed regulations provide that if the life expectancy is reduced to zero, the plan must distribute the employee's entire remaining interest before the last day of the year in which the life expectancy is reduced to zero to satisfy section 401(a)(9). These rules apply to IRA agreements and IRA owners as well. Many of the same concepts described above are applicable if the IRA owner's spouse is selected as a named beneficiary and the recalculation method is used.

Thus, if Davis elected to use the recalculation method and died at age 75 in 1998, her life expectancy would be reduced to zero in 1999. Accordingly, her estate would have to receive the entire balance remaining in the IRA during 1999 to avoid a 50% excise tax.

FIXED-NUMBER-OF-YEARS METHOD

If Davis had elected the fixed-number-ofyears method on or before her required beginning date, her estate could continue to receive distributions from her IRA annually until 2008. The tax-deferred growth of the IRA would continue despite Davis's death.

Under the fixed-number-of-years method, the method survives the taxpayer's death. The taxpayer's estate, as named beneficiary, succeeds to the remaining period of the fixed number of years. This rule also applies under the designation-of-beneficiary rules.

If the IRA custodian does not provide the taxpayer with the election form for the fixed-number-of-years method, the taxpayer should request one. If the custodian does not have an election form, the CPA will need to assist the taxpayer in creating one and deliver it to the custodian by no later than the required beginning date. Failure to act timely generally will result in selection of the life-expectancy recalculation method by default.

If the taxpayer elects the fixed-numberof-years method and his or her estate is the named beneficiary, at the taxpayer's death the estate can assign the remaining installments to the estate's beneficiaries to avoid prolonged estate administration.

In addition to electing the fixed-numberof-years method, the IRA owner also can enter into a separate agreement with the IRA custodian providing for certain taxplanning deferral arrangements that do not violate the required minimum distribution rules of section 401(a)(9).

A properly structured fixed-number-ofyears payment agreement between an IRA owner and the custodian should provide that, at the IRA owner's death, the estate (if it is the named beneficiary) may

* Accelerate distributions from the IRA.

* Continue to receive annual distributions from the IRA.

* Assign future IRA distributions to estate beneficiaries.

* Permit estate beneficiaries to receive annual installments from the IRA for the remaining fixed number of years.

* Permit estate beneficiaries to accelerate distributions from the IRA.

Sophisticated deferral agreements also may be structured if a named beneficiary such as a spouse, child or certain type of irrevocable trust has been timely selected by the IRA owner.

If an IRA owner is married and selects his or her spouse as a named beneficiary no later than the required beginning date, the IRA owner may elect on or before that date for IRA distributions to be paid over a fixed number of years based on the joint life expectancy found in table VI of Treasury regulations section 1.72-9. The fixed number of years for distribution purposes is based on his or her attained age and the spouse's attained age in the year in which the IRA owner turns age 701/2.

Many IRA agreements provide that if the IRA owner makes no election by the required beginning date, the recalculation method is the default option for both the IRA owner and spouse. The fixed-numberof-years method and the recalculation method rules described in this article are applicable if the spouse is the IRA owner's named beneficiary. If an IRA owner and his or her spouse defaulted into the recalculation method, at the IRA owner's death the surviving spouse as named beneficiary may use a spousal rollover technique to break the recalculation method.

The surviving spouse may not, however, roll over any required minimum distributions the IRA owner failed to receive in the calendar year of his or her death. However, if the spouse, as named beneficiary, predeceases the IRA owner while the recalculation method is applicable, the IRA owner may not break the recalculation method, and acceleration will take place one year after the IRA owner's subsequent death. The IRA owner cannot avoid the recalculation method after it is applicable by substituting a different named beneficiary for the spouse at a later date.

* MANY IRA OWNERS DEFAULT into a distribution method that may not be advantageous for surviving family members. This is particularly true if the owner and beneficiary die in their 70s. Proper planning can ensure IRA benefits continue long after the death of the owner and his or her named beneficiary.

* IRA DISTRIBUTIONS ARE subject to the required minimum distribution rules of Internal Revenue Code section 401(a)(9) and proposed regulations issued July 27, 1987.

* A TAXPAYER MUST DECIDE if he or she wishes to elect a fixed-number-ofyears for IRA distributions or to elect the life-expectancy recalculation method.

* THE RECALCULATION method expands the period of years over which IRA distributions may be taken. At death, however, payments must be accelerated, ending the tax deferred accumulation.

* ELECTING TO RECEIVE IRA distributions over a fixed number of years means the ultimate beneficiaries can continue payments for the remaining fixed number of years the distribution option survives the taxpayer's death.

* A PROPERLY STRUCTURED fixed-number-of-years payment agreement can provide additional flexibility at the IRA owner's death by allowing the named beneficiary to accelerate distributions if appropriate.