IRA Required Distribution Planning

IRA Required Distribution Planning

Planning for minimum distributions from traditional IRAs

In my last month's article, which dealt with who should be your beneficiary under either a qualified plan or your IRA, I pointed out that a cardinal rule of financial and estate planning is to delay and minimize plan distributions as long and as much as possible, both while the participant is alive and afterward, under the theory that deferring distributions is essential to maximizing growth in the plan.

If either you or your spouse need the moneys from your qualified plan or IRA, "stretching out" the benefits is not as important compared to a couple who does not need the moneys for support during their life time. The key to understanding the stretching out or deferral of your IRA property is minimum distributions.

What is minimum distributions? You can take all your IRA money out in a lump sum; you can take it out in roughly equivalent increments over your projected life span; you can take it out ratably over the joint projected life span of you and your spouse; or you can withdraw it ratably based on the projected joint life span of you and another beneficiary. (Theoretically, you are supposed to deplete your IRA accounts before you die.)

How do you know how long you will live? You don't. But the IRS provides tables that are based on mortality statistics. These statistics say a 70-year-old man will live until he is 86, so to deplete his IRA in relatively equal installments, he will take 1/16th (the 16 years he is expected to live after age 70) of his IRA money out in the first year of mandatory withdrawals and 1/15th of the remaining amount in the following year.

No later than the required beginning date (RBD), which for an IRA owner is April 1 of the year following the year in which he or she attains age 70-1/2, the remaining balances in his or her IRA must be distributed as indicated above.

The RBD is critical because failure to begin required minimum distributions (RMDs) by that date exposes the you to a penalty tax equal to 50% of the amount that should have been withdrawn but wasn't. The RBD also is vitally important from the planning standpoint. By that date, the taxpayer must choose a payout method that not only affects his or her retirement well-being but also affects the planning options that will become available to his or her surviving spouse and/or heirs.

An IRA owner who did not designate a beneficiary, or is treated as not having designated a beneficiary, has no choice but to calculate non-annuity type required minimum distributions (RMDs) over his or her life alone. In addition, even if an IRA owner designated beneficiaries, he or she may choose to receive RMDs over his or her life alone. There are, in turn, two ways to calculate non-annuity type required minimum distributions (RMDs) over the IRA owner's life.

 

Observation: From the IRA owner's standpoint, the recalculation method produces a longer payout period (and smaller distributions) than the term certain method, because the longer a person lives, the greater his chances of living longer than originally expected.

Required Minimum Distributions Over the Lives of IRA Owner and Spouse. An IRA owner who has designated his or her spouse as beneficiary can arrange to take non-annuity type required minimum distributions (RMDs) over his or her life and the life of his or her spouse using one of three calculated options:

 

Observation: If husband and wife are interested in maximum deferral for themselves, and are in good health, recalculating both life expectancies will yield the longest deferral period.

Example: Let's see how this would work. Let's assume John Doe and his spouse are age 70 and 68, respectively. John Doe owns an IRA with a value of $500,000 that will appreciate 10% over his lifetime. According to the IRS, John's life expectancy is 16 years, and his wife's life expectancy is 18 years. Using the recalculation of both lives, the value of the IRA at the date of death would be $792,054. If husband and wife are not in good health, using the term certain method for both lives assures a maximum deferral period for their beneficiaries should they both die relatively early in the distribution period.

Example: Using the same example above but using the term method over both John Doe and his spouse's lives, the value of the IRA at the date of death will be $605,578.

One way of "hedging the bet" is to recalculate the life of one spouse, and use the term certain method for the life of the other spouse. This way, the distribution period could be much longer than it would be if the term certain method were used for both spouses, but it still leaves the beneficiaries of the taxpayers with a deferral period in the event both spouses die before achieving a very old age. Which life to recalculate? It appears that the best approach is to use the recalculation method for the life of the spouse who is likeliest to survive to an advanced age. The term certain method should be used for the other spouse, i.e., the one who is likeliest to die early in the distribution period.

Required Minimum Distributions Over the Lives of IRA Owner and Nonspouse Beneficiary; Age Differential Doesn't Exceed 10 Years. An IRA owner who designated a nonspouse beneficiary who is not more than 10 years younger than the owner can choose to calculate non-annuity type required minimum distributions (RMDs) over:

 

Observation: Using the recalculation method, the joint life expectancy in the second year in the above illustration is reduced by more than it would be using the term certain method, i.e., from 21.7 years to 20.3 years instead of from 21.7 years to 20.7 years. On the facts in the above illustrations, it wouldn't be until the eleventh year that the joint life expectancy would be more using the recalculation method than it would be using the term certain. The net effect is that payouts in the early years are somewhat larger with the recalculation method than with the term certain method. However, the payout period using the recalculation method is potentially longer than it would be with the term certain method.

If the IRA owner survives to an advanced age, recalculating the IRA owner's life expectancy will result in a longer deferral period than the term certain method would produce. If the IRA owner dies before the IRA is depleted, the balance is paid to the designated beneficiary over what remains of the designated beneficiary's life expectancy, i.e., the beneficiary's life expectancy in the year distributions began less one for each passing year.

Required Minimum Distributions Over the Lives of IRA Owner and Nonspouse Beneficiary; Age Differential Exceeds 10 Years. Required distributions from an IRA during the owner's lifetime must satisfy the minimum distribution incidental benefit (MDIB) requirement if the designated beneficiary (1) is someone other than the owner's spouse, and (2) is more than 10 years younger than the account owner.

The MDIB requirement essentially provides that, where the spouse is not the designated beneficiary, the amount of the payments to be made to the IRA owner before death must be determined under the principles of the minimum required distribution rules, using a hypothetical individual not more than 10 years younger than the IRA owner as the owner's designated beneficiary.

Observation: The MDIB rules prevent a taxpayer from arranging for a very long deferral period by choosing a young beneficiary.

Life Expectancy Used Where There is More Than One Designated Beneficiary. An IRA owner may designate more than one beneficiary to receive his or her benefits after death. If two or more individuals are designated as beneficiaries, the designated beneficiary with the shortest life expectancy is the designated beneficiary for purposes of determining minimum required distributions.

Example: Ed designates his three children, Xavier, Yancy, and Zebulon as beneficiaries of his IRA. At Ed's required beginning date, he must start to receive distributions over a period that is not longer than the actual lives, or joint and last survivor life expectancy, of Ed and the oldest of his three children.

Observation: Where the children are beneficiaries, the MDIB rules will have to be used. Reason: Unless one of the children is adopted, they will be more than 10 years younger than the IRA owner.

If one of the beneficiaries is not an individual (or a trust whose beneficiaries are themselves treated as the designated beneficiaries), then the IRA owner is treated as having no designated beneficiary. This result applies even if the other designated beneficiaries are all individuals.

Conclusion: Before a person reaches their RBD, they should consult with their financial advisors to determine which method of calculation is the most advantageous for themselves as well as their heirs. The selection of the beneficiary for purposes of determining the required minimum distributions is important concerning how to stretch out the benefits of the plan, if this is an important goal for the participant and their heirs.

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