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Required
Minimum Distributions for Traditional and Roth IRAs
by
Gregory Kolojeski
with permission, January 1999
This
month we have a special guest author, Gregory Kolojeski. Gregory
is the editor of the excellent web site, www.rothira.com. Though
I consider Gregory to be a true expert in the area of required minimum
distributions, there is one area of his article where I wanted to
add a comment. My comment will appear as follows [Jim’s comment:……].
Introduction
At some point,
all IRAs must have their balances distributed. The rules which govern
those distributions are known as Required Minimum Distributions.
The Required Minimum Distributions rules are incredibly complex.
This article deals with how these rules operate and how they apply
to Traditional IRAs and Roth IRAs. Why are the Minimum Distributions
prefaced by the word Required? Simply put, there is a 50% penalty
for the amount of Required Minimum Distributions that are not distributed
as required.
Are Roth IRAs
Subject to the Required Minimum Distributions Rules?
You may sometimes
hear or see the statement that Roth IRAs are not subject to Required
Minimum Distributions. That is not really accurate. Roth IRAs are
not subject to Required Minimum Distributions during the owner's
lifetime, but are subject to Required Minimum Distributions after
the death of the owner. However, Traditional IRAs are generally
subject to Required Minimum Distributions beginning at age 70½.
One of the great advantages of Roth IRAs is that they are not subject
to these lifetime Required Minimum Distributions rules. This advantage
may be the single most valuable attribute of a Roth IRA.
If Roth IRAs
are not subject to Required Minimum Distributions rules during the
lifetime of the owner, do you need to be concerned about them? The
answer is that if you have a Traditional IRA or if you are considering
converting a Traditional IRA to a Roth IRA, you will still need
to be concerned about the Required Minimum Distributions rules.
You cannot do a valid comparison between a Traditional IRA and a
Roth IRA without taking into account the Required Minimum Distributions
rules. After all, the major advantage of a Traditional IRA is the
tax-deferred aspect of such an account. If you are forced to distribute
assets out of such an account, you lose that tax-deferral on the
amount distributed. So, to the extent that the Required Minimum
Distributions rules require you to take money out of the IRA that
you did not want or need to take out, you are being hurt financially
by those rules.
To What Types
of Pensions Do the Lifetime Required Minimum Distributions Rules
Apply?
The lifetime
Required Minimum Distributions rules generally apply to the following
types of pension plans:
- Corporate
and self-employed pension, profit sharing and stock bonus plans
qualified under IRC Sec. 401(a) (includes Keogh or H.R. 10 plans,
401(k) plans, and employee stock ownership plans or ESOPs).
- Individual
Retirement Accounts (IRAs) under IRC Sec. 408(a).
- Simplified
Employee Plans (SEPs) under IRC Sec. 408(k).
- Tax-sheltered
annuities (except for account balances existing on 12/31/86 if
kept separate for accounting purposes) under IRC Sec. 403(b).
What are the
Lifetime Required Minimum Distributions Rules?
The Required
Minimum Distributions rules generally apply when the owner of the
plan reaches what is known as the age 70½ year. You reach 70½ on
the date which is six months after your 70th birthday.
If you reach age 70 in January through June, that same calendar
year will be your age 70½ year. If you reach age 70 in July through
December, your age 70½ year will be the year AFTER your 70th
birthday. (Only the IRS could come up with rules like this!)
What is the
Significance of the Age 70½ Year?
Generally (which
means there are some exceptions), you must make a Required Minimum
Distribution for the year in which you turn age 70½. The Required
Minimum Distribution is the result of a simple calculation:
you divide the IRA balance from December 31st of the
preceding year by a Life Expectancy. The main complexity of the
Required Minimum Distributions rules derive from the determination
of that life expectancy. The IRA distribution rules also depend
on whether the owner of the Traditional IRA has reached what is
known as the Required Beginning Date. The Required Beginning Date
is April 1st of the calendar year following the year
in which the owner reaches age 70½. If the owner dies before the
Required Beginning Date, the distribution rules are different than
if he dies on or after the Required Beginning Date. The discussion
here will focus primarily on what happens if the owner lives at
least until his Required Beginning Date.
What is the
Significance of the Required Beginning Date?
If the IRA owner
dies on or after his Required Beginning Date, distributions from
the Traditional IRA will be determined by elections he did or did
not make. Required Minimum Distributions will be locked-in and will
only change due to certain other events (such as the death of the
owner or beneficiary or a rollover by a surviving spouse). It is
very important that one's distribution options be carefully considered
before one reaches the Required Beginning Date. Many IRA owners
will need to consult with a professional advisor in order to make
the best choice. The Required Beginning Date locks-in one’s
distributions based on the beneficiary selections. Circumstances
such as death may result in different beneficiaries later on, but
the selections in effect on the Requirement Beginning Date will
control the amount of those distributions.
Once you have
reached the age 70½ year, you must make a distribution each year
(i.e., no later than the end of the year) based on the Traditional
IRA balance as of December 31st of the preceding year.
The rule which allows you to distribute by April 1st
of the following year is a one-time exception that only applies
to the first year.
The best way
to understand this rule to look at an example. Let's assume that
an IRA owner was born on February 15, 1928. He would be age 70 on
2/15/98. He would be age 70½ on 8/15/98. His age 70½ year is 1998.
He must make a Required Minimum Distribution for 1998 by 4/1/99
based on the IRA balance as of 12/31/97. He must also make a Required
Minimum Distribution for 1999 by 12/31/99 based on his IRA balance
as of 12/31/98. In 2000, he must make a Required Minimum Distribution
by 12/31/00 based on his IRA balance as of 12/31/99 and so on. In
this example, the IRA owner has the option of making his 1998 Required
Minimum Distribution by 4/1/99 instead of by 12/31/98. The disadvantage
of making the 1998 distribution in 1999 is that he must also make
a 1999 distribution by 12/31/99. So, if he delays the first Required
Minimum Distribution until 1999, he will be making two Required
Minimum Distributions in 1999 and possibly pushing himself into
a higher tax bracket. In many cases, he would have been better off
making the 1998 Required Minimum Distribution in 1998 and the 1999
Required Minimum Distribution in 1999. Remember, it is only the
first Required Minimum Distribution that may be delayed until April
1st of the following year.
What Life Expectancies
May Be Used for Required Minimum Distributions?
There are two
life expectancy methods. One is known as the automatic refiguring
of life expectancy method (i.e., the Recalculation Method). The
other is known as the Term Certain Method. The Recalculation Method
is a life expectancy that is taken from an IRS table. When the Recalculation
Method is chosen, the life expectancy will generally decrease by
less than 1.0 per year. A Term Certain Method starts with a life
expectancy taken from an IRS Table, but that value will be decreased
by 1.0 for each successive year. The Recalculation Method results
in longer life expectancies, but it will become a 0 (zero) life
expectancy in the year after the person for whom it is used dies.
The Term Certain Method goes down by 1.0 per year and is unaffected
by when one dies. Depending on how long one lives, the Term Certain
Method may reach 0 before one dies or after one dies. What is the
significance of the life expectancy reaching 0? Unless some other
life expectancy becomes the controlling one, the entire Traditional
IRA balance must be distributed in the year the life expectancy
becomes 0.
Life expectancies
may be single life or joint life expectancies. (There is no apparent
advantage to ever choosing a single life expectancy if one has the
option of using a joint life expectancy.) Joint life expectancies
are based on two lives. When one is using a joint life expectancy,
it is possible for one of the life expectancies to be based on the
Recalculation Method while one is based on the Term Certain Method.
Furthermore, your ability to chose one method or the other depends
on your status. A Traditional IRA owner may choose either method.
A spousal beneficiary may choose either method. That is not true
for a non-spousal beneficiary.
A non-spousal
beneficiary may only use the Term Certain Method. Furthermore, while
the owner is alive, a non-spousal beneficiary must apply what is
known as the MDIB rules (IRC Proposed Treas. Reg. Sec.1.401(a)(9)-2).
The MDIB rule requires that no (non-spousal) distribution which
occurs after the Required Beginning Date be less than the one calculated
by dividing the Plan Balance by the factor from the MDIB Table divisor
from IRC Proposed Treas. Reg. Sec.1.401(a)(9)-2, Q-4. Effectively,
this requirement is triggered when the non-spousal beneficiary is
more than ten years younger than the IRA owner and will result in
a joint life expectancy factor for a person who is ten years younger
than the owner regardless of the actual age of the beneficiary.
The MDIB limitation may be removed after the death of the owner
if the owner has properly selected a designated beneficiary before
the owner's Required Beginning Date. (It might be a good idea to
include a statement that the MDIB requirement is to be removed for
the years after the death of the owner as part of a written beneficiary
designation). The MDIB rules usually result in considerably less
favorable life expectancies being used than would otherwise be the
case.
A spousal beneficiary
has a special benefit that may be elected after the death of the
original owner of an IRA. The spouse may elect to perform what is
commonly referred to a Spousal Rollover in order to become the new
owner. After a Spousal Rollover, the surviving spouse effectively
becomes the owner of the plan with most of the rules that applied
to the original owner now applying to the new owner. A non-spousal
beneficiary may never rollover an IRA and become the owner. This
benefit is only available to a spouse. Since the IRS has never ruled
on the subject, there is some controversy over what life expectancy
is used for the new owner’s beneficiary after a rollover when
the new owner is already past their Required Beginning Date. One
approach is to start the beneficiary with the IRS table life expectancy
for the year after the date of death and then subtract 1.0 per year
thereafter. Another approach is to go back to what would have been
the new owner’s age 70½ year had that person owned the IRA
at the time and start subtracting 1.0 per year from the beneficiary’s
life expectancy in the age 70½ year. (What’s worse, either
approach results in a life expectancy that is different than the
one used for the non-spousal beneficiary of a Roth IRA!)
As you can see,
the Required Minimum Distributions rules are horrendously complex.
The combinations and permutations boggle the mind. Professional
advisors generally need to use sophisticated computer programs to
review the options available to their clients.
Why should you
be concerned about which life expectancy (single or joint) or what
methods (Recalculation or Term Certain or some combination) are
used to determine Required Minimum Distributions? The goal is to
make choices which result in the most tax-deferral possible. In
other words, you want to have your Required Minimum Distributions
be the smallest value possible or last as long as possible. The
higher the remaining balance stays in an IRA or the longer that
the IRA continues in existence, the more tax deferral you will get.
The goal is to do whatever is permitted to allow your IRA balance
to provide as much benefit as possible (whether to you or to your
beneficiaries). Does it make sense to be concerned about the various
distribution options even if you think you will be withdrawing and
spending all the money in the IRA? Yes, because it is better for
you to control how the withdrawals are made rather than to be limited
by the government rules. You always have the option of taking more
out the IRA than what the Required Minimum Distributions rules require
you to take. But if you lock yourself into an unfavorable Required
Minimum Distributions scenario, you will be stuck with it. General
Rule: Always use a joint life expectancy when possible. Required
Minimum Distributions based on two lives will provide for much longer
distribution periods and smaller Required Minimum Distributions
than those based on single life expectancies. Assuming that joint
life expectancies are being used, the choices become the following:
- If both the
owner and beneficiary are using the Recalculation Method, the
calculated life expectancy is taken straight from Table VI of
Treas. Reg. Sec. 1.72-9.
- If both the
owner and beneficiary are not using the Recalculation Method (and
therefore are using the Term Certain Method), the life expectancy
in each year is set to their joint life expectancy in the 70½
year minus the number of years which have passed since then.
- If one is
using the Recalculation Method and the other the Recalculation
Method, the life expectancy in each year is determined using the
method from IRC Proposed Treas. Reg. Sec. 1.401(a)(9)-1, E-8(b).
This complicated hybrid method uses a modified age for the person
who has elected not to recalculate based on the deemed age for
the Term Certain life expectancy. With that deemed age for the
Term Certain Method and the actual age for the person using the
Recalculation Method, a joint life expectancy is selected from
Table VI.
Professional
advisors will often recommend the choice of a hybrid method with
the older person (assumed to be IRA owner for this discussion) using
the Recalculation Method and the younger person (assumed to be the
spousal beneficiary for this discussion) using the Term Certain
Method. In such a case, if the owner dies first (which will often
happen, particularly if the owner is a male and is older than the
spouse), the spouse will be able to elect a spousal rollover to
become the new owner. The surviving spouse then names a child as
beneficiary. If the spouse dies first, use of the Term Certain Method
continues with a joint life expectancy continuing to be used while
the owner is alive. After the owner dies and his Recalculation Method
goes to 0, any remaining Term Certain life expectancy will continue
to determine the distributions. This second scenario has the drawback
of not using the child’s longer life expectancy. A Roth IRA
conversion at that point would be one way to bring a child’s
life expectancy back into the picture.
[Jim’s
comment:…One of the problems in the area of choosing which
method of distribution is that if you do not make a choice, the
plan administrator or the company that is investing your funds is
likely to make a choice for you. Unfortunately, the choice the investing
company makes is quite often far less than optimal. Therefore, it
is absolutely critical that before you begin taking minimum distributions,
you make the proper determination of which method of distribution
is best for your circumstances and properly communicate your choice
to the plan administrator or company holding your retirement assets.
This is an area where I recommend professional guidance because
the laws are so complex. In addition, the importance of optimizing
this election cannot be overstated.
Another critical
election comes after the death of an IRA owner. A beneficiary would
be well advised to find out all of his/her options and make the
appropriate election. If it is available, the election to take minimum
distributions from the inherited IRA over the beneficiaries’
life expectancy can result in enormous tax-deferred growth. IRA
owners should inform beneficiaries or trustees for young beneficiaries
that it is imperative to seek the proper professional advice after
the IRA owner’s death.]
What
are the Required Minimum Distributions for Roth IRAs?
Roth IRAs are
not subject to the lifetime Required Minimum Distribution rules
since no distributions are required during the lifetime of the owner.
However, Roth IRAs are subject to Required Minimum Distributions
rules after the death of the owner of the Roth IRA with a 50% penalty
if such distributions are not made. The IRS released its interpretation
of the Roth IRA Required Minimum Distributions rules in Article
V of IRS Form 5305-R (Roth Individual Retirement Trust Account).
That form is a model trust agreement that most financial institutions
are likely to use (or to incorporate in their own agreements).
The model agreement
from the IRS provides for an automatic spousal rollover if the spouse
is the sole beneficiary of the IRA. That means the surviving spouse
automatically would become the new owner of the Roth IRA upon the
death of the original owner. Note: The surviving spouse would
need to name his/her beneficiary as soon as possible after the death
of the original owner in order for the rollover to be beneficial.
If a Roth IRA Agreement does not provide for a spousal rollover,
a surviving spouse would still have the option to elect to rollover
the Roth IRA to become the new owner. Why would you want to accomplish
a spousal rollover after the death of the original owner? If the
surviving spouse becomes the new owner, there will no requirement
for distributions to be made during the life of the surviving spouse!
That will result in additional tax-free growth of the account during
the surviving spouse's lifetime. A surviving spouse could take distributions
as a beneficiary, but there would rarely be any benefit to doing
so. Let's assume the owner (whether the original owner or the surviving
spouse who has accomplished a spousal rollover) of the Roth IRA
has died and that a beneficiary who is not the spouse is now subject
to Required Minimum Distributions rules. The beneficiary will have
to take out the entire balance by December 31st of the
year containing the fifth anniversary of the owner's death or the
beneficiary will have to start taking distributions over the beneficiary's
life expectancy starting no later the December 31st of
the year following the year of the owner's death. If distributions
to the beneficiary do not start by December 31st following
the year of the owner's death, the rule requiring a complete distribution
of the plan balance within five years will become effective. So
it is very important to properly start distributions in the year
after the owner's death if one wants to be able to take best advantage
of the Roth IRA. Generally, a written election to this effect should
be filed with the plan administrator as soon as possible.
A beneficiary
would be well advised to try to take advantage of the ability to
take withdrawals from the inherited Roth IRA over his/her life expectancy.
The funds in the Roth IRA will continue to grow and compound tax-free
while still part of the Roth IRA and the distributions from the
Roth IRA will be tax-free as well. Imagine having an account that
grows tax-free during your lifetime and pays you tax-free amounts
on a yearly basis! That is what a Roth IRA can be to your heirs,
such as your children and grandchildren. This after-death tax-free
growth is sometimes referred to as the stretch out IRA concept.
It is generally considered to be one of the two most valuable aspects
of a Roth (the other being the post-70½ tax-free compounding). While
Traditional IRAs also have a stretch out aspect, their tax-deferred
stretch out is considerably less valuable than the tax-free stretch
out offered by the Roth IRA.
How are Required
Minimum Distributions calculated for the beneficiary of a Roth IRA?
Let's assume
a Roth IRA owner who was born on January 1st dies at
the age of 90 and leaves the Roth IRA to a child who becomes 60
years old during that year. The child would have to take their first
distribution in the year after the owner's death or in a year when
they would be 61. The single life expectancy from the IRS tables
for a 61-year-old is 19.2 years. So in that year, they would have
to withdraw an amount equal to the preceding year's December 31st
balance divided by 19.2. The next year, they would reduce the life
expectancy value by 1 to 18.2 and then by 1 to 17.2 in the following
year and so on. This is the same Term Certain Method referred to
earlier.
The Term Certain
Method is the only method available to a beneficiary who is not
the spouse. One attribute of this method is that it does not depend
on the beneficiary's actual life expectancy. If one lives long enough,
the entire balance will have been distributed. If one dies before
the end of the payment period (effectively a 20-year pay out period
in the example), the payment stream could continue if the funds
are not fully withdrawn earlier. Note: Some IRA Agreements
require a full distribution after the death of the beneficiary.
Summary
The Roth IRA
Required Minimum Distributions rules are considerably easier than
the incredibly convoluted distribution rules for Traditional IRAs.
The possibility of making mistakes is lessened considerably thus
reducing the chances of expensive mistakes. And longer periods of
tax-free compounding will generally occur with the Roth IRA. The
biggest problem with the Roth IRA Required Minimum Distribution
rules is that the beneficiaries may not be aware of their requirement
to make such distributions. Anyone who starts a Roth IRA would be
well advised to inform the beneficiaries that they must make distributions
after the death of the owner or be prepared to pay a 50% penalty
on amounts that should have been distributed. Of course, beneficiaries
of Traditional IRAs have the same concerns with the addition of
much more complexity. As far as the distribution rules are concerned,
the Roth IRA is an easy winner when compared to a Traditional IRA.
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