Retirement

    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 ½. 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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