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 70^th 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 70^th 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 31^st 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 1^st 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 31^st of the preceding year. The rule which allows you to distribute by April 1^st 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 1^st 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 31^st 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 31^st of the year following the year of the owner's death. If distributions to the beneficiary do not start by December 31^st 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.

Let's assume a Roth IRA owner who was born on January 1^st 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 31^st 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.

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.