Important Changes to IRA and Pension Distribution Rules
This column has included many articles stressing the importance of contributing to employer-sponsored retirement plans as well as individual retirement accounts (IRAs). The importance of these to your long-term financial well being is underscored by the ongoing increases in longevity, rapidly increasing medical costs for the elderly and looming projected deficits in Social Security funding.
This article deals with the new Internal Revenue Service rules pertaining to annual minimum required distributions (MRD) from IRAs and other tax-deferred retirement accounts such as:
- 401(k)s (retirement plans held by many private-sector employees)
- 403(b)s (retirement plans held by many teachers and college professors)
- 457 (retirement plans held by many municipal workers).
The changes are effective immediately and are applicable to distributions in 2001. As discussed below, the changes will result in a reduction in the annual MRD for many retirees, providing them with a concurrent tax reduction. For many retirees, this reduction in annual MRD will help assure greater income if they attain very old age or, at minimum, provide an opportunity to leave more to their heirs. Note, however, that IRA trustees (i.e., banks, brokers and mutual fund companies holding the assets) are required to report to the IRA owner and the IRS the amount of the annual MRD. Having this information puts the IRS in a better position to monitor the distributions and enforce the penalties for failure to take the annual MRD.
IRS Simplified Rules for Determining Annual MRDsEarlier this year, the IRS provided new simplified rules pertaining to the annual MRDs retirees must take from tax-deferred retirement accounts once they turn 70. (Taking less than the minimum results in a steep penalty equal to 50 percent of the difference between the actual and required distribution.) The new rules greatly simplify the morass of rules that formerly governed the amounts that retirees were required to withdraw.
As noted above, the new rules generally reduce the annual MRDs. This change has two positive effects for many retirees. First, those retirees taking the smaller annual MRDs will have reduced tax liability. Second, taking smaller annual MRDs means that more will be available in the retirement accounts for subsequent years. This provides a buffer should the retiree live beyond the normal life expectancy. The changes do not affect the rules governing withdrawals prior to age 59. Furthermore, there is still no requirement for minimum withdrawals prior to reaching age 70.
For most retirees, computing the annual MRD is now a simple procedure. Just divide the prior year-end balance in your retirement account by the “applicable divisor” provided by the IRS at its site www.irs.gov (example follows). Refer to Pub 590, Appendix E. Appendix E provides divisors based on uniform lifetime expectancies starting at age 70 through age 115. Evidently, the IRS recognizes that some retirees may live for a very long time. If the retiree has a spouse who is more than 10 years younger, then the retiree may base distributions on actual joint life expectancies. A table providing these is also included in Appendix E. Retirees may, of course, withdraw more than the minimum distribution should financial needs dictate.
Using the divisors provided in Appendix E is quite simple. For example, if you are 70, the divisor is 26.2. Suppose the prior year-end balance in your retirement account is $300,000. You would divide the $300,000 by 26.2 = $11,450. The $11,450 is your MRD. Interestingly, if your account balance grew at 8 percent a year, the year-end balance in your retirement account after the $11,450 withdrawal would be approximately $312,000. For age 71, the divisor is 25.3, so you would have to withdraw about $312,000/25.3 = $12,332. For many retirees, the growth in minimum withdrawals should mitigate some or all of the impact of inflation. Assuming an ongoing 8 percent return, your account balance would continue to grow until age 87 when the divisor decreases to 12.4, thereby requiring you to withdraw more than 8 percent of the prior year-end balance in your retirement account.
Changing BeneficiariesThe new IRS rules also facilitate changing IRA beneficiaries. Under the new rules, changing IRA beneficiaries will not result in a faster payout. In fact, your lifetime payout could only lengthen. This could occur if you marry someone who is more than 10 years younger than you. It should be noted that provisions for pension plan beneficiaries are generally governed by law and require spousal consent.
The information and planning ideas contained in this article are for general use only. The article does not cover all tax changes. Therefore, the ideas presented here should be relied upon only when coordinated with professional tax advice.