Tax Relief - From an Unlikely Source

by Barbara Jo Smith and Clark Williams

Spring 2001

In January 2001, the United States Treasury Department issued new proposed regulations governing distributions from Individual Retirement Accounts (IRAs) and other retirement plans. These new proposed regulations reduce the minimum required distributions for most retirees and allow substantially longer pay outs to beneficiaries at the retiree's death. The regulations provide greater flexibility and eliminate several tax traps for the unwary.

The benefit of IRAs and retirement plans is the tax deferred growth of the funds. The new regulations will allow longer tax deferred growth for most people. IRA participants can take advantage of the new regulations immediately. New regulations are effective in 2002 for retirement plan participants unless the plan sponsor adopts an amendment to apply them in 2001.

During Life

After age 59 ½ the funds in an IRA may be withdrawn without penalty. For those persons who do not need immediate distributions for retirement, however, continued tax deferral is allowed to a point. On April 1 st of the calendar year after an IRA owner turns age 70 ½, the law requires certain minimum distributions for most persons.

The old rules required plan participants to select one of several methods to calculate the required minimum distributions. This election and the choice of beneficiary at that time determined the distributions to the participant and to the beneficiary after the participant's death. Once selected, the method could not be changed. Although the participant could change the beneficiary, the required distributions could not decrease.

The new regulations eliminate the need to make any elections. Instead, a single uniform table applies to everyone, regardless of the beneficiary. The table used to determine the minimum distributions is the most generous table allowed under the old regulations. For those with a spouse more than ten years younger, the minimum distributions can be even less. The participant can change the beneficiary at any time without affecting the amount of the distributions.

Starting in 2001, participants may elect to use the new regulations. Therefore, before taking any more distributions this year, those participants taking their minimum distributions should consult with their tax advisor. Greater deferral may be allowed.

Beneficiary's Rights After Death

Many people have accumulated much of their wealth within retirement plans and IRAs. Instead of using all of the funds for retirement, many persons are passing these funds on to their beneficiaries. The beneficiaries, of course, must pay income tax on the proceeds, and many beneficiaries are surprised when the tax bill comes due.

Under prior regulations, the participant's choice at age 70 ½ and the beneficiary named at that time controlled the timing of payments to the beneficiary. A different set of rules governed if the participant died prior to the age 70 ½ election. These two different sets of rules and the inability to change the outcome after the age 70 ½ elections created many traps for those who were not fully informed at the time of the election or for those whose situation later changed.

The new regulations are much more flexible. Regardless of whether the death occurs before or after age 70 ½, a designated beneficiary will be allowed to receive the remaining balance of the IRAs or retirement plan benefit over that beneficiary's lifetime. This results in "stretching out" the income tax recognition over 30 or 40 years with continued deferred growth during that time. The retirement benefits become, in effect, the beneficiary's retirement plan. Under the prior regulations, a non-spouse beneficiary was generally required to withdraw the entire balance within no more than five years after the death occurred.

Generally the designated beneficiary is the person named. The rules allow a trust to be named, but there are some steps to follow to maximize the stretch out. The plan participant can change the beneficiary after age 70 ½ to allow the new beneficiary the advantages of the new proposed regulations. In fact, even after the participant has died, disclaimers and actions by the beneficiary or beneficiaries can maximize the "stretch out." Any post-death distributions to beneficiaries, however, could eliminate this flexibility. Therefore, after a death, the beneficiaries should consult their attorney or income tax advisor prior to drawing any money out of an inherited IRA or retirement plan account.