Simpler Rules for Withdrawing Tax-Deferred Funds

In January 2001, the Internal Revenue Service dramatically simplified distribution rules for tax-deferred retirement plans, allowing retirees to take less money out of their accounts each year--and pay less income tax in the process.

The changes affect the millions of Americans who contribute to any of several types of tax-favored retirement plans, including individual retirement accounts, 401(k) plans, 403(b) plans and 457 plans, as well as millions of future retirees and their heirs. Though subject to public comment, the changes went into effect retroactively at the beginning of this month.

"These [changes] caught everybody out of the blue," said Stephen J. Silverberg, president of the Pension Council of Long Island and managing partner of Silverberg & Hunter in Garden City, N.Y. "It is really a good and significant change. It benefits almost everybody."

The rules create a simple formula for calculating a retiree's minimum distribution amount, replacing a more complicated system.

Previously, people with tax-deferred retirement plans such as IRAs and 401(k)s had to make an irrevocable "election" by April in the year after they turned 70 1/2. That decision determined how quickly they had to deplete the money in those retirement plans.

The old minimum distribution rules offered eight choices and little guidance as to which was the best choice for a given retiree. And once an election was made, a retiree was stuck with it forever, even if it meant taking more money out of the retirement plan each year than was needed. Not only would that mean paying additional income tax, but it would also leave less money in the account to grow tax-deferred.

Moreover, if an account holder died without making proper beneficiary elections, heirs could be forced to deplete the account almost immediately, often paying income tax at the highest marginal rates.

The new rules eliminate these problems. Not only do they make it easier to figure out how much needs to be withdrawn from a retirement account each year, they also allow current retirees to go back now and make changes in their withdrawal schedule.

Beneficiary designations also can be made posthumously--up to Dec. 31 in the year after the account owner's death--thanks to these revised regulations.

Here is how the new rules work and how they affect retirement-account owners.


Q: Why are the changes important?

A: At age 70 1/2, owners of IRAs, 401(k)s and other tax-deferred retirement accounts have to start withdrawing money from the accounts and pay the deferred income tax on the amount they withdraw. The reason: The IRS wants to collect the deferred tax before the account owner dies.

However, many retirees want to minimize the amount they withdraw from their tax-deferred accounts to avoid paying income tax on money they don't need.

The previous rules gave taxpayers eight choices to figure their required distribution. The formulas were complicated, and each resulted in a different annual amount.

The new rules simplify matters by letting retirees use the formula that allows the least amount of money to be withdrawn from an account each year--resulting in the lowest tax bill.

Retirees can calculate the withdrawal amount by using a age-related divisor provided by the IRS (see accompanying chart).

There is an exception: If a spouse is the IRA beneficiary and that spouse is more than 10 years younger than the IRA account owner, the distribution formula would be based on the actual ages of the account holder and the beneficiary. That allows such couples to stretch out distributions over the longest possible period.

Q: What if someone wants to take out more money than the formula requires?

A: That's always allowable. The IRS restricts you only from taking out less.

Q: Don't these "proposed" rules have to be finalized before they go into effect?

A: No. The rules on retirement-plan distributions that taxpayers have been following for 26 years have never been finalized. This new proposal is a revision of those past proposed rules, all of which were treated as the law of the land from the moment they were published.

Q: Why would the IRS do this if it means that everyone can pay less tax?

A: Under the old rules, no one knew precisely how much any given retiree should be taking out of his or her retirement account. Retirees had to figure it out themselves, and compliance was on the honor system.

Under the new rules, retirement-plan trustees must calculate the minimum required distribution for account holders and then report that amount to the IRS, making it much easier for the agency to track compliance.

Q: What happens to beneficiaries when an account owner dies? Do they have to withdraw all the money from the account immediately?

A: Assuming the beneficiary is valid, he or she can now take withdrawals from the retirement account over time. If an IRA is left to a spouse, for example, he or she would be able to roll it into a new IRA, name a new beneficiary--such as a friend or a child--and then start making withdrawals based on the new minimum distribution tables.

New Distribution Rules

To determine the required minimum yearly distribution from a retirement account under the new rules, divide the balance of the account at the end of the previous year by the figure next to the account holder's age.

Example: A 75-year-old with $100,000 in an IRA at the end of 2000 would divide $100,000 by 21.8. The minimum required withdrawal in 2001 is $4,587.16.