IRS Revises Rules for Mandatory Distributions
Retirees with substantial tax-sheltered nest eggs--and a desire to keep that savings sheltered for as long as possible--will find good news in the Internal Revenue Service’s newly revamped rules for mandatory distributions.
These are the rules that tell individuals the minimum amount they must withdraw from retirement savings each year.
Many retirees want that number to be as low as possible, so they can limit their current income taxes and allow their savings to last longer. The recent IRS rule change does just that.
But the mandatory distribution rules remain highly complicated, and retirees must to be careful not to run afoul of IRS regulations.
Here’s a look at the latest rule change and at the IRS’ clarification of another aspect of distribution requirements:
Question: What are mandatory distribution rules?
Answer: All types of retirement plans for which savers get an upfront tax deduction--IRAs, 401(k), 403(b) and 457 plans--require that individuals start taking money out of these accounts when the account holder hits age 70 1/2. The same applies to tax-deferred annuities.
The idea behind this requirement is simple: The government has waited a long time to tax this money, but it won’t wait forever. Mandatory distribution rules, which specify the minimum retirees must take out of tax-favored plans each year, mean to ensure that individuals pay tax on their retirement savings before they die.
Retirees can take more from savings than the rules specify; they just can’t take less.
The IRS first revamped its mandatory distribution rules in 2001, greatly simplifying them.
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Q: Why were the rules changed again?
A: First, last summer’s federal tax reform act required the IRS to use more current life expectancy tables than the decade-old figures the agency had been using. By updating the life expectancy tables this year to reflect that people are living longer, the IRS is giving seniors more time to take money out of retirement plans.
In addition, the agency was flooded with questions about its 2001 revision of the rules, and realized that although the regulations were less complex, they still were confusing enough to require clarification on some issues.
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Q: What do the latest changes mean in practical terms?
A: The lifespan change to the standard distribution table--called the uniform lifetime table--raises the divisor that retirees use to figure out how much they need to take from savings each year.
For example, with the previous formula, a 70-year-old with $500,000 saved would have had to take $19,084 out of his retirement accounts last year. With the new table, that retiree’s required distribution in 2002 drops to $18,248.
That allows the retiree to save $251 in current-year taxes--assuming he pays roughly 30% of his income in tax. It also allows him to leave an extra $836 in tax-deferred savings for another year.
Because the new formula allows similar reductions in the amounts that must be withdrawn in future years, experts believe the change will help ensure that more retirees won’t run out of savings.
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Q: Does everyone use the uniform lifetime table?
A: Most people do. But married couples with large age disparities--a difference exceeding 10 years--may instead choose to calculate a different distribution formula that’s based on their joint life expectancies. That would allow them to pull money out of retirement savings even more slowly.
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Q: What else did the IRS change in its latest revamp?
A: There was one significant clarification about how the mandatory distribution rules affect retirement account beneficiaries after the original account holder’s death.
In the IRS’ 2001 simplification of the mandatory distribution regulations, the agency said that designated beneficiaries could be determined by Dec. 31 of the year following the death, said Steven Silverberg, a New York-based tax attorney.
That led some to believe that heirs could change beneficiaries posthumously. But that wasn’t what the IRS intended. The agency was simply giving heirs the ability to remove “tainted” beneficiaries from the distribution formula, when several people or entities were named to get shares of the account, Silverberg said.
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Q: Why is that important?
A: Distribution rules require that all beneficiaries of a retirement account adhere to the distribution formula applied to the beneficiary who has the shortest allowed distribution schedule.
Tainted beneficiaries--that is, a beneficiary that is not a person but an entity such as a charity or trust--have no lifespan over which to stretch account distributions. So the IRS requires tainted beneficiaries to withdraw all account assets within five years of the original owner’s death.
The ability to remove a tainted beneficiary allows the remaining beneficiaries to take account distributions over the oldest beneficiary’s estimated lifespan, which helps those who don’t need the money right away and who don’t look forward to paying a big income tax bill.
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Q: How is a tainted beneficiary removed?
A: An estate would use other assets to buy out that entity’s interest in the retirement account. For instance, if a $100,000 IRA was left equally to a child and a charity, the child would be able to take $50,000 of other assets and give it to the charity to have that charity removed as a beneficiary.
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Q: What if the named beneficiary is a living trust?
A: Then the person’s heirs are stuck with the five-year formula, Silverberg said.
That makes it all the more important for anyone with a retirement account to fill out beneficiary paperwork and make sure they name beneficiaries and backup beneficiaries.
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Kathy M. Kristof can be reached at kathy.kristof@latimes.com.
