IRAs: What You Need to Know About the Minimum Distribution Requirements
An Individual Retirement Account (“IRA”) is a savings account set up at a financial institution that allows individuals to contribute monies which are to be used after an individual retires. These accounts are tax-preferred in that the IRS has specific, beneficial tax rules applicable to IRAs. There are several types of IRAs; the two most common are a traditional IRA and Roth IRA. An individual that opens a traditional IRA contributes pre-tax money into the account while employed, and then pays income tax on the distributions paid out during retirement. Tax savings occur in two ways: 1) the monies in the account are allowed to grow tax-free until the time of distribution, and 2) when an traditional IRA owner retires and no longer receives steady income, the IRA distribution is taxed at the owner’s current tax rate, which should be much lower than the owner’s pre-retirement tax rate. A Roth IRA is the opposite of a traditional IRA; an individual with a Roth IRA contributes post-tax monies to the account, and then receives distributions from the account tax-free. Similar to a traditional IRA, the money in the Roth IRA grows tax free, and when the IRA is ultimately distributed, all of the growth will be tax free.
Section 401(a)(9) of the Internal Revenue Code and its accompanying regulations provide the governing rules for IRAs. The government encourages individuals to save for retirement by granting preferential tax treatment to IRAs. However, the government places limitation on the ability for IRAs to transfer wealth between generations. To that end, the IRS forces owners to take certain required distributions from an IRA beginning at a certain age. These withdrawal rules are referred to as the required minimum distribution rules (“RMD rules”). In general, a traditional IRA owner will be forced to withdraw a minimum amount of money from the account in the year that he turns 70.5 years. Different RMD rules apply if an owner dies before age 70.5 and leaves an IRA to a designated beneficiary. The RMD rules do not apply to individuals with a Roth IRA that are currently living; however, certain RMD rules do apply to an individual who has inherited a Roth IRA.
The RMD rules are vast and complex but can be pared down into some main rules. An individual with a traditional IRA must begin taking a required minimum distribution from his IRA account in the year that he turns 70.5 years to avoid incurring any penalties (there are certain exceptions for an owner who is still working at that age). The RMD must be withdrawn by December 31 of each year; however, there are certain exceptions for the first year of distribution and several other specific situations. The RMD is calculated by locating the applicable life expectancy of the owner in the “Single Life Expectancy” actuarial table published by the IRS (IRS Publication 590), and dividing that number into the amount of money in the IRA on December 31 of the previous year. The table predicts the lifespan of the owner of the IRA and his spouse, who is deemed by the IRS to be 10 years younger. Other than taking the RMD each year, there is no cap on the total amount of money that an owner may withdraw each year.
The RMD rules are designed to distribute the account monies over the lifetime of the owner and his spouse. For instance, if an individual has $1,000,000.00 in an IRA at age 70, assuming a 6% return rate, the account should not begin to diminish until age 89. Thus, a significant chance exists that an owner will die with monies remaining in the IRA, and an owner may name a “designated beneficiary” to receive any monies remaining in the account. A “designated beneficiary” is any individual designated as a beneficiary of the plan by the employee. An estate and trust are not individuals; however, a trust may be named as a designated beneficiary as long as certain requirements are met, which will be discussed below. A designated beneficiary who inherits an IRA possesses an aptly-named “inherited IRA,” which involves a different set of RMD rules.
Unlike the owner of the IRA, who does not have to begin taking distributions until age 70.5, a non-spouse individual who inherits an IRA as a “designated beneficiary” must begin taking RMDs immediately, regardless of her age. The money in the account is still allowed to grow tax-free, and is taxed at the beneficiary’s individual tax rate in the year that she receives a distribution. The RMD is calculated using the beneficiary’s life expectancy, not the existing life expectancy of the original IRA owner. This is referred to as “stretching” an IRA because the monies in the account are paid out over the lifetime of the non-spouse beneficiary, which, in most cases, is likely to be much longer than the owner’s. If there are multiple beneficiaries of an account, a plan administrator may roll the IRA into separate inherited IRA accounts so that each beneficiary may use his or her own age to determine the RMD. This can have particular benefits for a Roth IRA where the original owner did not take any RMDs from the IRA during lifetime.
The owner of an IRA may also name a trust as the primary beneficiary, which might be done for a number of reasons: 1) to preserve the stretch of an IRA for the maximum period of time, 2) to assure that the IRA stays in the original owner’s family (a child who inherits an IRA outright may name his or her spouse as a beneficiary), 3) to protect the IRA in the event of the beneficiary’s divorce or from creditors, and 4) to prevent a spendthrift beneficiary from withdrawing all of the money at once.
The trust is specifically designed to hold an IRA as a trust asset, and it must include very specific terms to maintain the beneficial tax treatment of the IRA. The IRS looks “through” the trust, and treats the trust beneficiaries as the designated beneficiaries of the IRA. A trust that names multiple beneficiaries must include specific language that divides the trust into sub-trusts for each beneficiary, thereby allowing each beneficiary to use his or her own age to stretch the RMD. If the sub-trust language is not included in the Trust, the RMD will be calculated using the age of the oldest trust beneficiary. Consider the undesired example wherein a father designates a trust as primary beneficiary, and the trust names his two adult children as beneficiaries, ages 40 and 30. If there is no sub-trust language, the RMD will be calculated using the age of the 40 year-old only, and the 30 year-old will be forced to take distributions over a shorter period of time thereby depleting the account much faster.
IRAs are great retirement vehicles that can provide significant tax savings, and may also turn into beneficial wealth management vehicles. If you have questions about your estate plan, and how your IRA can be preserved for the next generation, please contact our office for more information.