IRS Proposes Revised Minimum Distribution Rules

Participants in qualified retirement plans and tax-deferred annuities (TDAs), as well as owners of "traditional" individual retirement accounts (IRAs), are required under Section 401(a)(9) of the Internal Revenue Code to take minimum distributions of their accumulated benefits once a specific date has been reached. Until recently, guidance from the Internal Revenue Service (IRS) in this area had been based upon regulations proposed in 1987 but never finalized. These proposed regulations have been heavily criticized for being unnecessarily complex. As a result, noncompliance has been a problem, particularly as to IRA owners who have not been advised by trained professionals.

The consequences of noncompliance are draconian: a plan can lose its tax-qualified status and the affected person is subject to a 50% penalty on the amount which should have been distributed but was not.

Last month, the IRS released a new set of proposed regulations, with the goal of making it easier for both plan participants and IRA owners to understand and apply the minimum distribution requirements. The new proposal, while hardly simple itself, does indeed provide more workable rules and will, in fact, allow many affected persons to take required distributions over a longer period than was permitted under the 1987 proposal.

This Update will provide a brief overview of some of the key aspects of the 2001 proposed regulations, focusing primarily on required distributions from IRAs. Many of the same rules outlined here also apply to qualified plans and TDAs, although most distributions from defined contribution plans [such as 401(k) and profit-sharing plans] are paid in single-sum form within one year after termination of employment.

There are three types of required IRA distributions: (i) those to the IRA owner once he reaches the "required beginning date" (RBD); (ii) those which are paid if the IRA owner dies before the RBD; and (iii) those which are paid if the IRA owner dies after the RBD.

The RBD is April 1 of the calendar year following the calendar year in which the IRA owner attains age 70-1/2. In the case of a qualified plan or a TDA, a participant's RBD is usually April 1 following the later of (i) the calendar year in which he attains age 70-1/2; or (ii) the calendar year in which he retires. However, for a participant who owns 5% or more of the business sponsoring the plan, the RBD is determined the same way as under an IRA. The IRA rule may also apply to all participants in some qualified plans and TDAs which have not been amended as permitted under other IRS regulations.

Under the 1987 proposed regulations, an IRA owner who reached the RBD could always receive minimum distributions over his life expectancy or over a period certain based on his life expectancy, regardless of who was designated beneficiary or even if there were no designated beneficiary. His required distribution for each calendar year would equal his IRA balance at the end of the previous year divided by a divisor. At the time of his RBD, he would have to choose between the "recalculation" or "non-recalculation" method for determining the divisor.

"Recalculation" under the 1987 proposed regulations meant using as the divisor the IRA owner's life expectancy, under the IRS single-life expectancy table, corresponding to his attained age in each year for which a distribution was required. "Non-recalculation" meant using his life expectancy in his 70-1/2 year as the first year's divisor, and reducing such divisor by one each subsequent year. This terminology has been the source of endless confusion for many persons, who quite naturally assumed that they were "recalculating" if they reduced their divisor by one each year.

If an IRA owner wanted to prolong required distributions under the 1987 proposed regulations, he could use the joint life expectancy of himself and his "designated beneficiary," but this presented its own set of problems. If the designated beneficiary were an individual other than the IRA owner's spouse, the recalculation method could be used only as to the IRA owner, with the non-recalculation method being used for the beneficiary. Also, if there were a non-spouse designated beneficiary who was more than 10 years younger than the IRA owner, a special table had to be used to determine required distributions. If the named beneficiary were not an individual, required distributions had to be based on the IRA owner's life expectancy alone, except for special rules for trusts under which individuals were entitled to receive the IRA distributions.

The 2001 proposed regulations eliminate many of these rules and instead generally require that the divisor for required distributions to an IRA owner be determined under a single table, regardless of who is the named beneficiary as of the RBD and even if there is no named beneficiary as of the RBD. There is no longer any need to choose between the recalculation and non-recalculation methods. The table for determining the divisor for an IRA owner, based on his attained age in a particular calendar year, is as follows:

(For space reasons, the required divisors for ages 91 and above are not shown.) For example, an IRA owner born March 1, 1931 would reach age 70-1/2 in 2001. On his birthday in 2001 he would be 70, and so the initial required distribution, for the year 2001 (which can be paid as late as his RBD, April 1, 2002), would be his IRA balance at December 31, 2000 (the year before his 70-1/2 year), divided by 26.2. Similarly, the divisor for determining the required distribution for the year 2002, payable by December 31, 2002, would be 25.3.

The above table is the same as the table which was used under the 1987 proposed regulations for an IRA owner whose designated beneficiary was a person who was not his spouse and was more than 10 years younger than he. Except for IRA owners who designate as beneficiaries their spouses who are more than 10 years younger, most IRA owners will be able to prolong their distributions by using this table instead of having to determine each year's divisor under the 1987 proposed regulations.

Using the above table would adversely impact an IRA owner with a spouse more than 10 years younger who was the designated beneficiary. Under the 1987 proposed regulations, an IRA owner who named his spouse as beneficiary could take required distributions based on the actual life expectancies of himself and his spouse, regardless of the spouse's age. The 2001 proposed regulations address this issue by permitting such an IRA owner to use the recalculation method as to both life expectancies, if it results in a greater divisor than under the above table. In order for this special rule to apply, the spouse must be the sole beneficiary at all times during the calendar year for which a required distribution is due.

If the IRA owner dies before his RBD, the distribution period depends on whether there is a "designated beneficiary." Under the 2001 proposed regulations, the determination of whether there is a designated beneficiary is made not at the time of the IRA owner's death, as under the 1987 proposed regulations, but instead as of the last day of the calendar year following the calendar year of his death. An IRA owner can designate any beneficiary he desires, such as one or more individuals, his estate or a charitable organization. In order for there to be a designated beneficiary, however, the beneficiary must be one or more individuals. A trust can be named as beneficiary, however, and if certain requirements are met, the beneficiaries of the trust's interest in the IRA will be treated as if they were beneficiaries of the IRA.

If one or more individuals are the designated beneficiary, the balance in the IRA will be distributed over a period certain based on the life expectancy of the oldest beneficiary, determined as of the calendar year following the calendar year of the IRA owner's death using the IRS single-life expectancy table. If the designated beneficiary is not the surviving spouse, payment must begin by the end of the calendar year following the calendar year in which the IRA owner dies; the minimum distribution for the calendar year following the year of the IRA owner's death is the IRA balance as of the preceding December 31, divided by the beneficiary's life expectancy. For each subsequent year, the divisor is reduced by one.

If the surviving spouse is the sole IRA beneficiary, payment can be deferred until the end of the calendar year in which the IRA owner would have attained age 70-1/2, if this is later than the end of the calendar year following the calendar year in which the IRA owner died. Each year's required distribution is determined based on the spouse's life expectancy for that year; thus, the spouse's life expectancy is recalculated annually. In the event of the spouse's death before the IRA has been completely distributed, the divisor for determining the required distribution in subsequent years is based on the spouse's life expectancy in the year of her death, reduced by one each year. Consequently, after the spouse's death, her life expectancy is no longer recalculated. (The spouse may, of course, choose to receive a distribution of the entire IRA balance and roll it over to her own IRA, in which event she would be treated as the IRA owner for purposes of the minimum distribution rules.)

If there is no designated beneficiary by the end of the calendar year following the year of the IRA owner's death, the IRA balance must generally be distributed in full within five years after the IRA owner's death.

An IRA can provide that the five-year rule will apply to distributions after the owner's death even if there is a designated beneficiary. In the absence of such a provision in an IRA, the life expectancy rule will apply if there is a designated beneficiary.

Under the 2001 proposed regulations, if the IRA owner dies on or after the RBD, determining required distributions for calendar years following the calendar year of his death depends on whether or not there is a designated beneficiary as of the end of the calendar year following the year of his death. If there is a designated beneficiary, the rules are the same as those outlined above when the owner dies before the RBD, and thus differ depending on whether or not the sole beneficiary is the surviving spouse.

If there is no designated beneficiary, then the divisor for determining required distributions for calendar years following the calendar year of the owner's death is based on his life expectancy in the year of death, reduced by one for each calendar year thereafter.

In an effort to improve compliance, the 2001 proposed regulations would require IRA trustees to report to both the IRA owner and to the IRS the amount required to be distributed each calendar year from the IRA. These proposed regulations make it much easier than the 1987 proposal for IRA trustees to calculate the required amount for distributions on or after the RBD, as the distribution period is always based on a single table depending on the IRA owner's age, regardless of the identity of the beneficiary, if any. No specific reporting rules have yet been proposed, however.

The IRS is considering whether to expand this reporting to TDAs as well. However, no reporting would be required as to minimum distributions from qualified plans.

The 2001 proposed regulations, when finalized, will apply to required distributions for calendar year beginning on or after January 1, 2002. For the year 2001, qualified plans and IRA owners can rely on either the 2001 proposed regulations or the 1987 proposed regulations. If the final regulations, or other IRS guidance, is more restrictive than the provisions in the 2001 proposed regulations, such guidance will be issued without retroactive effect.

Qualified plans, TDAs and IRAs will eventually have to be amended to incorporate the final regulations, after they are issued. It is not advisable to make amendments at this time based on the 2001 proposed regulations.

Those persons who have reached the RBD should determine whether they could reduce their required distributions for 2001 by taking advantage of the 2001 proposed regulations. In addition, these persons should re-evaluate their estate plans, particularly as to the naming of a beneficiary. Greater flexibility is now possible in connection with naming a trust as beneficiary. If one intends to make charitable bequests, the 2001 proposed regulations make it more advantageous to do so through an IRA.

Individuals who have not reached the RDB should also consider the effect of the 2001 proposed regulations on their tax and estate planning.

First published in February 2001