News Releases
Inherited IRA Grandfather Rule Expires at the End of This Year!
December 23, 2003
Inherited IRA Grandfather Rule Expires at the End of This Year!
December 23, 2003
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December 23, 2003
News Release from: Ed Slott, CPA Publisher, Ed Slott's IRA Advisor Rockville Centre, NY 100 Merrick Road Rockville Centre, NY 11570 516-536-8282 Email: Ed Slott Attention IRA Beneficiaries: Inherited IRA Grandfather Rule Expires at the End of This Year! You must act now to qualify for an expiring tax provision. Not doing so could cost you a fortune in unnecessary income taxes by causing all of your inherited IRA to be taxed. By Ed Slott, CPA ©2003 How IRA Beneficiaries Switch to the New Rules Key Points: A little known IRA grandfather rule can save some IRA beneficiaries a fortune in tax, but they must act NOW. This grandfather rule will EXPIRE FOREVER at the end of this year (in one week). If you are an IRA beneficiary and inherited under the old rules, you may be able to extend the life of your inherited IRA by switching to the new rules (the April 2002 Final Regulations). This grandfather rule affects only those beneficiaries who were actually named as beneficiary on the IRA beneficiary form. It does not apply if you inherited through an estate. You must have been named on the beneficiary form To qualify under the grandfather rule, you must take all prior year catch up distributions from your inherited IRA by the end of this year. Below are the details excerpted from the June 2002 issue of Ed Slott's IRA Advisor when the rules were first released. They expire forever in one week. How IRA Beneficiaries Switch to the New Rules The April 2002 Final Regulations (the new rules) give many IRA beneficiaries who inherited under the old rules (from the 1987 Proposed Regulations) a second chance to keep their inherited IRAs growing longer. They will be permitted to switch to the new rules and extend the life of their inherited IRAs. Under the old rules, many of these beneficiaries would have been forced to empty the IRAs in a few years. Every IRA beneficiary who is taking distributions based on a shorter life expectancy than their own should look at these new rules and see if the distribution schedule can be lengthened. Some beneficiaries will increase the life of their inherited IRA by more than ten times. Imagine being able to add more than 40 years to the life of your inherited IRA instead of having to withdraw it all in the next 2, 3 or 4 years. There are two groups of beneficiaries affected. 1. Beneficiaries using the 5-year rule 2. Beneficiaries withdrawing based on life expectancy. Beneficiaries in this category may be withdrawing over their own or someone else's life expectancy This article will focus on beneficiaries currently using the 5-Year rule. Beneficiaries using the 5-year rule The 5-year rule is only applicable if the IRA owner dies before his Required Beginning Date (RBD). Only designated beneficiaries can switch from the 5-year rule to the new Single Life Table and only if the plan allows it. These are individual beneficiaries who were named by the IRA owner. If they are using the 5-year rule because they inherited through the estate, they CANNOT switch to the new rules. These beneficiaries must continue under the 5-year rule. Under the old rules a beneficiary may have been named, but still was stuck with the 5-year rule because he did not know that he could have used the life expectancy method and stretch required distributions over his life expectancy. That can now be changed. The April 2002 Final Regulations state that the designated beneficiary can switch from the 5-year rule to the new Single Life Table, providing that prior year distributions that would have been required are made up by the earlier of December 31, 2003 or the end of the original 5-year term. If you were named as the IRA beneficiary by the IRA owner (NOT his estate), and you are withdrawing under the 5-year rule, the example below will show you exactly how to switch to the new rules. The first step is to calculate and make the distributions that would have been required for the prior years as if you had elected the life expectancy method. Once you are caught up, you simply continue taking required distributions over your remaining life expectancy based on your age in the year after the IRA owner's death. The plan must allow the switch to the life expectancy method. No 50% Penalty on Catch-up Distributions The 50% penalty for not taking a Required Minimum Distribution (RMD) will not apply to the distributions taken for the prior years (the catch-up distributions) when switching from the 5-year rule to the life expectancy method. Even though the distributions were not taken in those years, under the Final Regulations, the distributions are not referred to as required distributions. The catch-up distributions were not required for the back years because the beneficiary was withdrawing under the 5-year rule at that time. The only requirement under the 5-year rule is that the entire inherited IRA account is emptied by the end of the 5th year after the year of the IRA owner's death. Instead of these prior year distributions being called "required distributions" the Final Regulations refer to them as distributions that "would have been required." Reducing the IRA Balance for Catch-Up Distributions In the examples below and in the May 2002 issue we took the position that when a beneficiary switches to the life expectancy method from the 5-year rule, he can reduce the prior year IRA balances by the distributions that would have been required. There is no official position from IRS on whether you can make these reductions, however the IRS has said in informal discussions that this would be appropriate. Also in IRS Revenue Procedure 2001-17 (see below) and other Revenue Procedures, the IRS has used this reduction in calculating amounts of missed required distributions. These were all in audit and 50% penalty scenarios and not in a situation where a beneficiary is taking a catch-up distribution that was not originally required at the time. The catch-up situation is new. From Revenue Procedure 2001-17, Appendix A, .06 Failure to timely pay the minimum distribution required under section 401(a)(9). In a defined contribution plan, the permitted correction method is to distribute the required minimum distributions. The amount to be distributed for each year in which the failure occurred should be determined by dividing the adjusted account balance on the applicable valuation date by the applicable divisor. For this purpose, adjusted account balance means the actual account balance, determined in accordance with section 1.401(a)(9)-1 Q&A F-5 of the proposed regulations, reduced by the amount of the total missed minimum distributions for prior years. In a defined benefit plan, the permitted correction method is to distribute the required minimum distributions, plus an interest payment representing the loss of use of such amounts. We'll have to wait for IRS to issue a Notice or ruling on how to calculate the back year (catch-up) distributions under the Final Regulations. The reduction would be to the beneficiary's advantage and we will take that position in this newsletter until IRS states otherwise. Calculating the Catch-Up Distributions Example: The IRA owner died at age 65 in 1997 and his son was the named beneficiary of his $500,000 IRA. His son was 46 years old in 1997. The son did not elect life expectancy (even though he could have) and has defaulted to the 5-year rule. He has not taken any distributions through 2001. Under the 5-year rule, the entire account balance must be withdrawn by the end of 2002 because that is the 5th year following the year of the IRA owner's death. Under the new rules, the son can switch to the life expectancy method using the new Single Life Table, but he must first take the distributions that would have been required for 1998, 1999, 2000 and 2001 had he elected to withdraw using the life expectancy method. Assume that the plan allows the switch to the 5-year rule. He will calculate those distributions using the old Single Life Table that was in effect for those years. He will also base each year's distribution on the IRA account balance at the end of the prior year. He must calculate and withdraw distributions that would have been required for 1998, 1999, 2000 and 2001. When he does the calculation for 1998 (the first required distribution), he will use the December 31, 1997 IRA balance. For the 1999 required distribution, he will use the December 31, 1998 balance, but he will reduce that balance by the amount of the 1998 distribution, even though the distribution was not actually taken until 2002. The 2000 and 2001 required distributions will be taken using the same method as the 1999 distribution, where the prior year's account balance is reduced by that year's and prior years catch-up distributions. Reducing the prior year's account balance is to the beneficiary's advantage because it reduces the amount of the required distribution. For 2003 and later years distributions, no reduction is permitted. This was added to the Final Regulations to simplify the required distribution calculation. Similarly, additions to the year-end IRA or plan balance for contributions made after year-end are also not required. Under the Final Regulations, the catch-up distributions for years 1998-2002 must all be withdrawn by December 31, 2002, because that is the earlier of December 31, 2003 or the 5-year term. In this example, the 5-year term ends December 31, 2002 because the IRA owner died in 1997. In 2002, the four catch-up distributions for 1998-2001 plus the 2002 required distribution will be taken. All 5 years distributions will be taken in 2002, but that will still leave the lion's share of the IRA available to be withdrawn over the remaining life expectancy of the son. Even after paying tax on the 5 years of distributions in one year, the 2002 tax bill will be substantially lower with the new rules. Under the old rules, the entire $500,000 (or whatever the remaining balance is at the end of 2002) would have been taxable in 2002. In this example, the son must calculate and withdraw the required amounts for 1998-2001 as if he had been using the life expectancy method all along. Assume the following IRA balances at year-end: December 31, 1997 $500,000 December 31, 1998 $550,000 December 31, 1999 $580,000 December 31, 2000 $600,000 December 31, 2001 $570,000 In addition to the 1998-2001 distributions, the 2002 required distribution must also be taken by the end of 2002. The 2002 distribution can be calculated using either the old rules or the new rules, but for many beneficiaries switching from the 5-year rule, using the old rules will work out better (a lower distribution for 2002). Even though you have the option of using either rules for 2002 distributions, you cannot mix and match. You cannot use the best parts of the old rules with the best parts of the new rules. If you use the old rules, you can reduce the prior year's account balance by the distribution for that year, but you must stick with the old table. If you choose to use the new rules, you will use the new table, but you cannot reduce the prior year's balance. In this example you will see that it is better to use the old rules for the 2002 distribution. Reducing the prior year balance for distributions taken produced a lower required distribution. Calculating the 1998 Required Distribution (the first year's required distribution) IRA balance at December 31, 1997 = $500,000 $500,000 divided by 35.9 years = $13,928 $13,928 is the distribution that would have been required for 1998 had the son elected the life expectancy method. He must take that distribution by the end of 2002. 35.9 years is the life expectancy factor from the old Single Life Table for a 47-year old. You look up the life expectancy for a 47-year old because you use the son's age in the year after the IRA owner's death. He was 46 years old in 1997 (the year of death), so you use age 47 for the year after death (1998). Calculating the 1999 Required Distribution IRA balance at December 31, 1998 = $550,000 $550,000 less $13,928 = $536,072 You reduce the prior year's ending balance by the amount of that year's required distribution even though the actual distribution was not taken until 2002. The prior year's distribution (for 1998) is $13,928 as calculated above and the $550,000 December 31, 1998 balance is first reduced by the $13,928 before you divide it by the life expectancy factor. $536,072 divided by 34.9 years = $15,360 You divide by 34.9 years because you reduce the 35.9-year life expectancy by one for each future year. $15,360 is the distribution that would have been required for 1999 had the son elected the life expectancy method. He must take that distribution (in addition to the 1998 distribution) by the end of 2002. Calculating the 2000 Required Distribution IRA balance at December 31, 1999 = $580,000 $580,000 less $29,288 = $550,712 The reduction of $29,288 is the total of the 1998 and 1999 year distributions (the $13,928 for 1998 plus the 15,360 for 1999 = $29,288). You reduce the prior year's ending balance by the amount of the two prior required distributions even though the actual distributions will not be taken until 2002. The prior year's IRA balance of $580,000 is first reduced by the $29,288 before you divide it by the life expectancy factor. $550,712 divided by 33.9 years = $16,245 You divide by 33.9 years because you reduce the life expectancy by one for each future year. $16,245 is the distribution that would have been required for 2000 had the son elected the life expectancy method. He must take that distribution (in addition to the 1998 and 1999 distributions) by the end of 2002. Calculating the 2001 Required Distribution IRA balance at December 31, 2000 = $600,000 $600,000 less $45,533 = $554,467 The reduction of $45,533 is the total of the 1998, 1999 and 2000 year distributions (the $13,928 for 1998, plus the 15,360 for 1999, plus the $16,245 for 2000 = $45,533). You reduce the prior year's ending balance by the amount of the three prior required distributions even though the actual distributions will not be taken until 2002. The prior year's IRA balance of $600,000 is first reduced by the $45,533 before you divide it by the life expectancy factor. $554,467 divided by 32.9 years = $16,853 You divide by 32.9 years because you reduce the life expectancy by one for each future year. $16,853 is the distribution that would have been required for 2001 had the son elected the life expectancy method. He must take that distribution (in addition to the 1998, 1999, and 2000 distributions) by the end of 2002. Prior Year Distributions that will be taken in 2002: 1998 RMD $13,928 1999 RMD 15,360 2000 RMD 16,245 2001 RMD 16,853 Total $62,386The $62,386 must be withdrawn in 2002. In addition, the 2002 required distribution must be withdrawn in 2002. Calculating the 2002 Required Distribution You begin by again looking up age 47 (the son's age in the year after the IRA owner's death) from the old Single Life Table. That factor is 35.9 years. You now reduce that factor by one year for each year that has passed since 1998. The life expectancy factor for calculating the 2002 distribution is 31.9 years (the 35.9 years less the 4 years since 1998 = 31.9 years). For the 2002 distribution, the son could have applied the new rules and used the new Single Life Table, but then he would not be able to reduce the account balance by the prior year distributions. Without that reduction, he would have had to withdraw $1,360 more from the account. In this example, choosing the old rules to calculate the 2002 distribution was to his advantage. The December 31, 2001 IRA balance is $570,000, but as with the prior years, that gets reduced by the 1998 - 2001 distributions calculated above of $62,386. However, beginning in 2003, under the April 2002 Final Regulations, the account balance does NOT get reduced by distributions taken after the distribution year. In this example we reduced the $570,000 IRA balance by the RMD of $62,386 because the reduction (which lowers the RMD) is still available for 2002 distributions. $570,000 less $62,386 = $507,614 $507,614 divided by 31.9 years = $15,913 $15,913 is the RMD for 2002 Recap of RMDs that must be taken in 2002: Total of prior years RMDs $62,386 2002 RMD 15,913 Total distributions in 2002 $78,299The result is that only $78,299 must be withdrawn by the end of 2002. If the son were forced to stick with the 5-year rule, the entire $570,000-plus IRA balance would have had to be withdrawn in 2002. By switching to the new rules, over $500,000 remains in the inherited IRA and that can be stretched over the son's remaining 32-year life expectancy. If in the example above, the IRA owner died in 1996, then the new rules would not help because the entire account would have had to be paid out by the end of 2001. The new rules would also not help if the beneficiary was the estate or if there was no designated beneficiary. Only a beneficiary who was named by the IRA owner (a designated beneficiary) can switch from the 5-year rule to the life expectancy rule. Taking Credit for Prior Year Distributions In the above example we assumed that no distributions were taken from 1998-2001 because the beneficiary had intended to withdraw the entire balance in the inherited IRA at the end of 2002. Under the 5-year rule, no distributions were required in 1998-2001. But how would this example change if the beneficiary took withdrawals in some of those years. If the beneficiary took the required withdrawal in 1998 (based on his life expectancy) he would have qualified for the life expectancy method under the old rules and would not have been stuck with the 5-year rule. But if he did not withdraw in 1998 (the year after the IRA owner's death), then under the old rules he defaulted to the 5-year rule. Assuming he withdrew nothing in 1998, and defaulted to the 5-year rule, how would the example change if he withdrew $50,000 in 2000? There is no direct reference in the Regulations, but it would seem that the $50,000 distribution would satisfy the distributions for the prior years, but any excess could not be used to satisfy future year distributions. The Regulations never allowed credit to a future year, but IRS did allow credit for a prior year in cases where required distributions were made up in a later year. In this example then, the $50,000 would satisfy the distributions that would have been required for 1998, 1999 and 2000. Those amounts were $13,928 for 1998, $15,360 for 1999 and $16,245 for 2000. They add to $45,533, leaving an excess of $4,467 (the $50,000 withdrawn in 2000, less the $45,533 = $4,467). The $4,467 excess cannot be carried over or credited to the amount that would have been required for 2001. The $16,853 that would have been required for 2001 must be taken in full. Ed Slott, CPA Copyright © 2003 Excerpted from Ed Slott's IRA Advisor (June 2002 issue) Publisher, Ed Slott's IRA Advisor 100 Merrick Road - Suite 200 East Rockville Centre, New York 11570 (516) 536-8282 email: Ed Slott website: http://www.irahelp.com |
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