Recent Changes for IRAs and Retirement Plans

The IRS has just released new rules for IRAs and employer-sponsored retirement plans (e.g., 401(k) plans). The sweeping changes are effective immediately. However, IRA owners may continue to apply the old rules for the year 2001.

Surprisingly, the IRS has taken a number of complex rules and turned them into a rather simple formula for determining how much money is required to be withdrawn from an IRA or employer-sponsored retirement plan. The old rule required distributions when the account owner reached age 70. Since distributions from an IRA or retirement plan are taxable for federal income tax purposes, there was an incentive to reduce the required annual distribution to the lowest amount possible.

Under the old rule, there were three ways to calculate the required annual distribution: recalculation, term certain, and a hybrid method. Unfortunately, once selected the method to calculate distributions became irrevocable and each method produced a different required distribution amount. Furthermore, each method produced a different income tax result at the account owner’s death.

The new rule requires distributions commencing at age 70. The method of determining the annual required distribution is calculated based on the joint life expectancy factor of the account owner and the life expectancy of someone who is assumed to be 10 years younger than the account owner. The only exception to this rule is if the joint life expectancy is based on the life of a spouse more than 10 years younger than the account owner. In this situation, the IRS will permit the actual joint life expectancy. The overall effect of the new rule is that most participants will enjoy a decreased minimum annual payout. Remember: the required minimum distribution is just that; it is the minimum amount that the account owner must withdraw for the year. Additional amounts may be taken if desired.

Upon the death of the account owner, if the beneficiary is the surviving spouse, the surviving spouse may roll over the account into his or her own name; this has not changed from the old rule. However, if the beneficiary is not a spouse, the beneficiary will be required to take minimum distributions over his or her life expectancy. The most probable result is a longer payout period for the beneficiary.

The drawback of the favorable changes is that the investment company will be required to report your projected minimum required distribution to the IRS. If you fail to take the required minimum distribution and pay income tax thereon, you are likely to be hit with a 50% penalty on the amount not withdrawn. Although this penalty has been in existence for a number of years, the IRS had a difficult time enforcing it because the calculation of the required minimum distribution was so complex and differed from taxpayer to taxpayer.

Overall, the changes should be beneficial to most account owners and complying with the new rules should not be difficult. However, failure to comply is sure to come to the attention of the IRS.

— Leslie Heffernen

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