IRA Distributions

I. Introduction – Distribute as little as the law requires and allow for tax free compounding

1. Goal: Maximize the amount of dollars after taxes arising out of your retirement plans and going to your children or other beneficiaries.

2. Assumptions: You will not need to take out more than the minimum distributions for your support. The estate tax exemption is $1,000,000 (the year 2011 and beyond).

3. Key Principle: Otherwise taxable investments compound tax-free in a retirement plan, and so we want to delay distribution as long as the IRS allows.

Bottom Line:

How much child has from $300,000 IRA after income taxes when child passes away

Old Rules

$1,610,766

New Rules

$2,157,299

4. Importance:

a. Minimum Distributions: The IRS will make you begin taking distributions from your IRA in the year you reach age 70 ½ or at the latest by April 1st of the following year.  In general, if you do not need the money, you want to delay distributions as long as possible to allow the tax-free build-up inside the IRA of otherwise taxable investments.

b. Beneficiary: After you die, the IRS will force the distribution of your IRA. The question is over what period of time? Again, we want to delay distribution as long as is possible to allow the tax-free buildup.

c. Significant Asset: Increasingly more significant in overall net worth of individuals.

d. Complex Issues: Best way to distribute during life and after death, complex mix of income tax, estate tax, and non-tax issues.

5. Most Important and Frequently Forgotten – What Does the Plan Say?: Terms of the plan agreement control benefits. May be inflexible or may be supplemented.

6. Other Factors:

a. Financial Needs.

b. Health of You and Your Spouse/Child.

II. Minimum Distribution Requirements – Definitions:

1. Required Beginning Date (“RBD”):

a. IRA’s and Qualified Plan Where More than 5% Owner of Business: April 1st of the calendar year following the calendar year in which owner attains age 70 1/2. Example: John Single turns age 70 on October 8, 2002. He turns age 70 ½ on April 8, 2003. His Required Beginning Date is April 1, 2004.

b. Qualified Plan Where Less than 5% Owner: Later of above or the year of retirement from the company.

2. Designated Beneficiary: A person (or a beneficiary of an irrevocable trust) who is the beneficiary of the IRA and then can be used as a “measuring life” in determining a joint life expectancy. For example, the life expectancy of a 70 year old is 16 years. On the other hand, the joint life expectancy of a 70 year old and a 60 year old (in other words, how many years until we expect both to be deceased) is 26.2 years.

3. Required Minimum Distribution: When you reach your RBD (remember that means “required beginning date”), your IRA must be:

a. Entirely distributed to you (and you get hammered with income taxes); or

b. Distributed to you in annual installments paid over a period no greater than:

i. Your life expectancy;

ii. The joint life expectancy of you and a “designated beneficiary.”

4. Distribution Year: A year in which you must take an RMD, a Required Minimum Distribution. The year in which you turn age 70 ½ is the first Distribution Year. However, you can defer taking the first RMD until the RBD, April 1st of the second distribution year. Normally it is good to defer income taxes. Nevertheless, you then get taxed on both the first and second year distributions in the second year. Example, John Single must take two distributions in 2004, and the second distribution may be taxed in a higher income tax bracket. However, the benefit of tax-free compounding in the IRA may offset the extra income tax cost of waiting.

5. Excise Tax: Failure to take the RMD in any year results in an excise tax equal to 50 percent of the shortfall between the amount, if any, distributed and the RMD. (IRS may waive penalty if a reasonable error.) For example, if John Single’s RMD for the first Distribution Year is $10,000 but he fails to take a distribution, the Excise Tax would be $5,000.

6. Repeal of 15% Additional Estate Tax on Excess Accumulations and Excess Distributions Excise Tax: In the 1997 Kevin Staker Full Employment Act, I mean, excuse me, the 1997 Taxpayer Relief Act, Congress repealed the 15 percent additional estate tax on “excess retirement accumulations” and the 15 percent Excess Distributions Excise Tax.

6. New Distribution Rules – 2001: In January 2001, oneof the last act of President Clinton was to liberalize the minimum distritbution rules.  In the past, we had to worry extensively about who the beneficiary of the IRA was.  Now, during life we use the life expectancy of the participant and an imaginary person 10 years younger. This is called the “MDIB” rule.  However, if you are so fortunate as to have a spouse more than 10 years younger than you, you use that longer joint life expectancy.

III. Optimizing Distributions:

The Bottom Line: Designated Beneficiary and Calculation Method

Type of Participant

Designated Beneficiary (“DB”)

Calculation

Method

Single Person

Individual(s) or Irrevocable Trust

MDIB Rule

Single Person

Estate (no beneficiary, do not do this! name a beneficiary)

MDIB Rule

Single Person

Charity

MDIB Rule

Married with all children with this spouse – no need to use IRA to use estate tax exemption

Spouse

MDIB Rule

Same but IRA needs to use estate tax exemption

Irrevocable Trust for benefit of spouse – not a QTIP trust

Same

Married with children of prior marriage – IRA not needed to use estate tax exemption

Irrevocable Trust for benefit of Spouse – a QTIP Trust

Same

Same but IRA needed to use estate tax exemption

Irrevocable Trust for benefit of spouse – not a QTIP Trust

Same

1. Calculating the RMD is mathematically simple: divide the IRA balance by a life expectancy factor. That is the question: which life expectancy factor results from the method used.

2. Death of Participant Prior to Required Beginning Date:

a. Not a qualified “designated beneficiary”: None, estate, charity, living trust – All IRA must be distributed by December 31st of fifth anniversary of participant’s death.

b. Qualified “designated beneficiary” (not spouse): Child, Other Individual, or Irrevocable Trust: Distributed over life expectancy of (oldest) beneficiary.

c. Spouse as Beneficiary: Spouse may rollover into IRA or may receive distributions over life expectancy. Almost always will rollover.

3. Death of Participant After Required Beginning Date:

a. Same as above. However, if using joint life expectancy with Designated Beneficiary, distributed over joint life expectancy (unless using recalculation method as to life of participant or DB).

4. Trust as Beneficiary – Underlying Beneficiaries as “Designated Beneficiaries”: On January 26, 1999, the IRS issued REG-209463-82, 1999-4 I.R.B., which amends the Proposed Regulations under IRC section 401(a)(9). For a trust now to qualify as a Designated Beneficiary:

a. Valid under state law (or would be but for the fact it has no corpus);

b. is or becomes irrevocable upon the death of the participant;

c. trust beneficiaries identifiable from the trust instrument; and

d. the IRA custodian/issuer or plan administrator is provided with either of the following and the participant must agree to provide a copy of any future amendment:

i. a copy of the trust; or

ii. a certified list of trust beneficiaries, including all contingent beneficiaries, with a description of the portion to which they are entitled and any conditions on their entitlement.

Therefore, a living trust or a sub-trust formed under it at death, may qualify as a Designated Beneficiary. Thus, a bypass, “B,” exemption, decedent’s, or whatever it is called trust, that receives the first assets of a deceased spouse up to his or her estate tax exemption (2002=$1,000,000), may receive the retirement benefits.

Note: either (1) the final updated trust instrument or (2) a final certification of trust beneficiaries must be provided to the plan administrator within nine months of death of the participant.

How Can I Find Out More?

To learn more about irrevocable trusts for retirement plans, or if you would like a free consultation to learn if this type of irrevocable trust is right for you, please do not hesitate to contact us at (805) 482-2282, or e-mail us at  KGS@Staker.com.

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