A new ruling by the Internal Revenue Service (IRS) may enable your individual retirement account (IRA) to last longer.
As discussed in the June, 2001 Lane Report, after reaching age 70½, participants in qualified retirement plans and IRA account holders are required to take at least a minimum distribution from their accounts each year. However, Federal law not only prescribes when you must begin taking distributions, but also sets an age before which you may be penalized if you do take distributions — age 59 ½. Distributions from qualified plans or IRAs made before the plan participant or account holder reaches age 59 ½ are normally subject to a 10% penalty tax. (For the rest of this Lane Report, I will refer only to IRA holders rather than participants in qualified plans. While the principles discussed are the same for both IRAs and qualified plans, qualified plan participants are generally more restricted by plan rules in their ability to receive early distributions than are IRA holders who control their own accounts.)
However, there are some exceptions to the 10% penalty tax. One such exception exempts distributions if the distribution is “part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary.” Internal Revenue Code § 72(t)(2)(A)(iv). “Substantially equal” periodic payments are those calculated by means of one of three methods prescribed by the IRS: the required minimum distribution (“RMD”) method, the fixed amortization method, and the fixed annuitization method. Although the amount withdrawn according to the RMD method may vary from year to year, the other two methods are notable in that the amount to be withdrawn from the IRA each year will be constant. In other words, the account holder uses formulas provided by the IRS to determine an amount which, if withdrawn annually from the IRA, is expected to deplete the IRA over the account holder's life expectancy (or over the combined life expectancy of the account holder and the designated beneficiary).
However, the decline in the stock market over the last two years has created problems for some IRA holders who have been taking fixed distributions according to the fixed amortization method or the fixed annuitization method. With the value of the stocks held in their IRAs declining, account holders may find that continuing to take the same distribution annually could deplete their IRAs while they are still alive, leaving them short of funds later in life. Until recently, the IRS severely restricted IRA holders from modifying their schedule of substantially equal payments or the method used to calculate such payments — either by increasing or decreasing the amount distributed from the IRA — before reaching age 59 ½ or within five years after beginning the series of distributions. Any IRA holder who made such a modification would be subjected to the 10% penalty tax as to all prior distributions made before the account holder reached age 59 ½, plus interest. This has placed some IRA holders in a dilemma — either continue to receive IRA distributions on their established schedule and run the risk of depleting the IRA in their lifetimes, or reduce the distributions and pay the penalty tax and interest.
Revenue Ruling 2002-62 is intended to alleviate this problem. It does so by allowing account holders who begin distributions using the fixed amortization or the fixed annuitization method to make a one-time switch in a subsequent year to using the RMD method. The RMD method requires the account holder to calculate his or her annual payment each year by dividing the account balance for that year (typically the value of the IRA as of the preceding December 31) by a divisor taken from an IRS life expectancy table corresponding to the account holder's age each year. If the account holder uses the RMD method consistently, the IRS will consider the account holder to be taking a series of substantially equal periodic payments, even though the actual amount of each payment is likely to vary from year to year. An advantage to the RMD method is that the divisor table provides that the account holder will never be required to take a distribution that would entirely deplete the IRA.
The following is an example of how the RMD method is used. The same procedure will be followed regardless of whether the account holder had previously used the fixed amortization method or the fixed annuitization method or had not taken any distributions at all.
Example: Andrea was born in 1959. She decides to begin taking distributions from her IRA according to the RMD method in 2003 and to use the uniform lifetime table in Revenue Ruling 2002-62 to calculate her distributions. The value of her IRA as of December 31, 2002 is $50,000.
The divisor prescribed by the uniform lifetime table for a 44-year-old person (Andrea's age on her birthday in 2003) is 52.4. Therefore, Andrea divides $50,000 by 52.4 to arrive at her distribution for 2003, which would be $954.20.
In 2004, Andrea looks to the value of her IRA as of December 31, 2003. She finds that its value has dropped as a result of both the distribution and a decline in the value of the stock held therein, and that the IRA's value as of December 31, 2003 is only $47,000. She divides this amount by the appropriate divisor for a 45-year-old person, which is 51.5, and thus takes a required distribution of $912.62 in 2004.
Fortunately for Andrea, the value of the investments in her IRA rebounds, leaving the IRA with $52,000 in assets as of December 31, 2004. Andrea divides this amount by 50.5, the divisor for a 46-year-old person, and takes the required distribution of $1,029.70 in 2005.
Once Andrea begins taking distributions using the RMD method, she should continue to use this method to calculate her annual distribution for at least five years, or until she reaches age 59 ½, whichever is later. If she fails to do so, the 10% penalty tax will be imposed.
It should be noted that those account holders who continue to use the fixed amortization or fixed annuitization methods to calculate the distributions from their IRAs will, at least, not have insult added to injury — if they can no longer take substantially equal periodic distributions because the assets in their IRAs are completely depleted, they will not be subjected to the 10% penalty tax on the distributions they took before reaching age 59 ½.
If you're currently taking equal distributions from an IRA annually, you may well be using the fixed amortization or the fixed annuitization method. If so, and you're concerned about the possibility of running out of IRA assets later in life, switching to the RMD method may well suit your needs. For further details, please consult us; we'll be happy to help.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.