Provided by the Law Offices of
RICHARD MAYBERRY
MAYBERRY LAW FIRM
2010 Corporate Ridge
McLean, VA 22102
(703)714-1554
Committed to providing the highest quality estate planning legal
services for individuals, families and businesses |
It has been said that there are two things you should never watch while
they are being made: one is sausage and the other is tax law. The same can
be said of most tax law changes. Invariably they only result in more
complex do’s and don’ts, not to mention stiff penalties for
non-compliance. Historically, this has been especially true of the
long-standing regulations governing distributions from IRAs. That said, on
January 11, 2001, the IRS issued sweeping changes to these regulations
that should help IRA* owners and their beneficiaries keep more wealth in
their own pockets.
To better appreciate and understand the impact of
these new regulations, we will review some unique tax characteristics of
IRAs, introduce three foundational concepts common to both the former and
the new regulations, consider some key changes that benefit both taxpayers
and the IRS under the new regulations, and note some new post-mortem
planning opportunities.
Unique
Assets
IRAs are unique assets. Their fundamental purpose
is to help taxpayers send some of today’s dollars ahead for tomorrow’s
retirement. [Note: IRAs were never intended as vehicles to build large
estates for heirs.] To facilitate their fundamental purpose, IRAs enjoy
preferential tax treatment during their creation and as they accumulate.
They are created with pre-tax dollars and then grow tax-deferred.
Consequently, through the tax-deferred annual compounding of their
interest and dividends, IRAs often grow to produce rather impressive
account balances. Because of their preferential tax treatment, all
distributions from IRAs are fully taxed as ordinary income.
Here is where taxpayers and the IRS have
competing goals. Taxpayers want to delay distributions from their IRAs and
enjoy the tax-deferred compounding as long as possible. The IRS, on the
other hand, wants to see taxpayers take distributions and pay taxes on the
full distributions at ordinary income rates. Unfortunately, the IRS writes
the regulations.
In 1987, the IRS issued extremely complex
regulations to force IRA owners to begin taking Minimum Required
Distributions (MRDs) and to identify their Designated Beneficiaries (DBs)
no later than a standard Required Beginning Date (RBD). A basic
understanding of these three foundational concepts is essential to
understanding the regulations governing IRA distributions. [Note: These
concepts are common to both the former and the new regulations.] MRDs are
the minimum distributions an IRA owner must take each year. The penalty
for non-compliance is stiff. The IRA owner must not only pay income taxes
on the full amount that should have been distribution, but also an
additional excise tax of 50% on the MRD amount that should have been
distributed but was not. DBs, as the term suggests, are the parties (or
the party) the IRA owner designates to receive any undistributed funds in
their IRA post-mortem. The RBD is the date when the IRA owner must begin
taking MRDs or risk the 50% excise tax described above. The RBD is April
1st of the calendar year following the year during which the IRA owner
reaches age 70 ˝. While the new regulations retain these three
foundational concepts, they make significant changes in their application.
Something
Old
Under the 1987 regulations, calculating MRDs was
nothing short of a nightmare. Both during the lifetime and following the
death of the IRA owner, calculating the appropriate MRD was often
extremely complex and varied wildly depending on many factors. Such
factors included several irrevocable decisions determined no later than
the RBD of the IRA owner. For example, which of several complex and
irrevocable calculation methods the IRA owner selected (in the absence of
a timely selection, the IRS applied a default method), who or what the IRA
owner selected as their DBs, and whether the IRA owner was already taking
MRDs at the time of their death. Simply put, it was nearly impossible to
accurately calculate lifetime and post-mortem MRDs and the potential
penalty for non-compliance was nothing short of draconian. Ironically,
these same complex regulations that made taxpayer compliance more
difficult also thwarted their enforcement by the IRS.
Something
New
While the deadline for MRDs remains the RBD under
the new regulations, calculating MRDs is now surprisingly simple.
Virtually every IRA owner will use one new uniform table to recalculate
their MRD each year. An exception is an IRA owner whose spouse is more
than 10 years younger. Such an IRA owner may elect to use the more
favorable of either the new uniform table or the IRS Joint Life and Last
Survivor Expectancy table. All taxpayers will see a reduction in their
MRDs with this simplified approach to MRD calculations…and the IRS will
see an increase in its tax collections from IRA distributions. How? The
new regulations require IRA providers to annually report the year-end IRA
balances of each IRA owner and the amount of their MRD for each year in
question. With virtually all IRA owners (and their DBs) using one uniform
table to calculate MRDs, it will be easy for IRS computers to cross-check
the MRD reported on an IRA owner’s tax return with the MRD reported by
the IRA provider. Bottom line: What is good for the goose is good for the
gander, too.
Post-Mortem
Planning
Unlike under the 1987 regulations, an IRA owner
now may change their DB anytime until their death, instead of being
irrevocably locked-in to lifetime and the post-mortem MRDs based on a DB
selection made at their RBD. Furthermore, this choice of DB is not
finalized until December 31st of the year following the death of the IRA
owner. That means there is ample time for some significant post-mortem
planning to potentially save additional income taxes. [Note: The power of
such planning is made possible because each individual DB uses the same
uniform table to determine their own MRD.] Here are three common DB
scenarios that stand to benefit from the new regulations.
First, an older primary DB may want to consider
disclaiming their interest in an IRA to a younger contingent beneficiary
(e.g. son to grandson). This causes the IRA to bypass them in favor of the
younger DB. Such a disclaimer can, in effect, create what has been called
a Stretch IRA by stretching the MRD over the longer life expectancy of the
younger DB.
Second, prior to the new regulations, naming a
charity as a Co-DB with an individual DB accelerated the distributions to
both. Under the flexibility afforded under the new regulations, the
charity now may be cashed-out before finalizing the DB for the IRA. This
permits the individual DB to calculate their MRD under the uniform table.
Finally, when multiple individual DBs are named
under the same IRA, the IRA now may be divided into separate accounts to
allow each DB to individually determine their MRDs using the uniform
table. Formerly, all DBs had to use the life expectancy of the eldest
named DB to determine their MRDs.
Recommended
Reviews
In light of the new regulations, every IRA owner should review their DBs,
regardless of whether MRDs have begun. This includes situations where any
trust has been named as a DB, whether primary or contingent. Furthermore,
IRA owners currently taking MRDs (and DBs who are currently taking
post-mortem MRDs) should immediately recalculate their MRDs for 2001.
Summary
The sweeping changes to the regulations governing IRAs extend well beyond
the scope of this brief overview. As with any major tax law changes, it
may be prudent to consult with legal counsel to evaluate the impact of the
new regulations on your plans.
*
Although the IRS proposes that the new regulations will become final for
calendar years beginning on or after January 1, 2002, IRA owners can
either use the former regulations or start using the new regulations to
calculate MRDs for 2001. However, participants in Qualified Retirement
Plans cannot use the new regulations until their respective plan sponsors
adopt a Model Plan Amendment contained in the new regulations.
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