A significant change has been made in the rules for required minimum distributions from retirement plans, and these changes can be helpful in the wealth and income planning process for many people.
Required minimum distributions apply to several types of retirement plans, including qualified retirement plans satisfying the rules of Section 401(a) of the Internal Revenue Code of 1986, Section 403 annuities, Section 408 individual retirement accounts and Section 457 deferred compensation plans. A characteristic linking all of these types of arrangements is that there is a deduction or exclusion for contributions made to them, and their growth, through investment of contributions, enjoys a deferral of income tax. As a result, there is a substantial deferral of income tax liability on the contributions and the income earned on them. Calculations have been made to demonstrate that this tax deferral regime is one of the largest tax expenditures provided by the code. Intuitively, it seems clear that the longer the day of tax payment can be postponed, the more favorable the situation for the taxpayer and the less favorable to the tax collector.
The federal taxing authorities have long taken the position that retirement plan rules are designed to provide a source of income during the retirement years of the individuals who participate in retirement plans. They are not designed principally to be a means of accumulating wealth to pass on to the next generation. If a participant dies before receiving all of the retirement benefits accumulated, there can be a transfer of wealth between generations and, for at least some individuals, that will be the largest portion of the wealth transferred; or, to state it differently, many people are only successful in accumulating significant wealth through retirement vehicles. This transmission of wealth is permissible, although the combination of federal estate taxes and federal estate taxes on the retirement balances can be confiscatory.
It’s also easy to understand that the longer distributions from retirement plans can be postponed, the more likely it is that the retirement plan will be effectively converted into a wealth transfer mechanism. This, the taxing authorities maintain, is not and should not be the principal purpose of the tax provisions encouraging retirement saving; and, further, extended postponement of the taxation of tax-favored contributions and earnings is harmful to the collection of tax revenues in any particular year. It is for these reasons that rules were added to the code providing for required minimum contributions: The tax benefits should at some point be reversed by subjecting retirement benefits to taxation, and it should be at a time and in a manner that encourages gradual distribution over the expected period of retirement. The rules requiring such distributions are set forth in Section 401(a)(9) of the code, as interpreted by regulations that were issued over a period of many years and were put into final form only in recent times. A sign of the seriousness of this issue, to the taxing authorities, is the 50 percent penalty imposed on taxpayers to the extent distributions fall short of the required minimum.
(These rules don’t apply to Roth IRAs during the life of an individual who sets them up. This seems logical: There is no deduction or exclusion from taxable income for contributions to the Roth IRA, so there is less concern about reversing the effect of beneficial tax provisions in early years. The rules also don’t apply to the earnings on Roth IRAs, which can be free of tax, which seems less logical, but it’s surely easier to exempt the entire Roth IRA from minimum distributions than to try to divide it between the two elements and have minimum requirements for a portion of the Roth IRA.)
The rules on required minimum distributions must rank as some of the most complex in the code. The most ambitious and comprehensive book on the subject, Natalie Choate’s “Life and Death Planning for Retirement Benefits,” takes more than 500 pages to explain how the rules operate. The basic rule, which has many exceptions and nuances, can be stated as follows: Distributions from covered retirement arrangements must begin by April 1 of the year following the year in which the individual attains age 70-and-a-half, and must follow a minimum schedule for that year and succeeding years that generally is based on the life expectancies of the individual and a hypothetical spouse who is 10 years younger. Individuals who have a spouse more than 10 years younger benefit by having a longer payout period, and perhaps in other ways. In the first year of distribution, the required amount is slightly less than 4 percent of the value of the account determined as of the end of the previous year, and the percentage required rises slowly thereafter; so much so that, in normal periods of investment returns, some time ago, it was possible for the value of a retirement account to continue to increase for a number of years after the distributions had begun.
Note the requirement that the percentage be applied to the value of the account at the end of the previous year. If the retirement account had a high value at the end of the prior year, but that value declined precipitously during the final year, the amount to be withdrawn could end up being a much larger percentage of the value of the retirement account at the time the distribution occurs. The result could be that the retirement account would decline faster than was consistent with the need to make retirement income last for a long period of time. Of course, the opposite could occur: The account could increase in value in the succeeding year, with the result that the actual percentage withdrawn could be lower. The latter situation could occur at some future date, but the former certainly occurred in 2008. Security values were still at a very high level at the end of 2007 but declined dramatically during 2008.
This problem was considered serious enough that it was felt that some legislative relief was necessary. This legislative relief came in the Worker, Retiree, and Employer Recovery Act of 2008, the unpronounceable WRERA. WRERA suspended the minimum distribution requirements for 2009. There was an effort made to obtain relief for 2008 minimum distributions as well, through action by the Treasury Department, but the effort began late in the year, after many people had already taken their minimum distributions for the year, and the Treasury refused to take any further action. As a result, participants who had to take a required distribution in 2008 did so on the basis of the higher values at the end of 2007, the very result the new law hoped to avoid. If minimum distributions were required in 2009, they would have been based on the lower values at the end of 2008. Perhaps the waiver for 2009 is meant to make up for the problem caused by the 2008 minimum requirements. And, of course, many people will not have the luxury of being able to eliminate distributions in 2009, because they need the funds to live on.
The IRS has issued Notice 2009-9 to explain how this one-year waiver of the minimum distribution rules operates, and this notice has already been the subject of much commentary, including some inevitable questions about the interpretation of the relief in specific circumstances.
As the notice points out, section 201 of WRERA waives required minimum distributions for 2009 from many types of plans. They include defined contribution plans, which have individual accounts for participants (such as 401(k) plans), Section 403(a) retirement accounts, Section 403(b) tax-sheltered programs for teachers and others, Section 457(b) plans for governmental employers and individual retirement accounts. Here’s a simple example:
Sally has been retired for many years and began receiving distributions from her IRA a few years ago, when she reached age 70-and-a-half. Despite having received a minimum required distribution in 2008, her required minimum for 2009 will be zero. Any amount that she does withdraw will be subject to federal income taxation.
As mentioned above, the first distribution from a retirement plan is required to be made by April 1 of the year following the year in which age 70-and-a-half is attained. If someone turned 70-and-a-half in 2008, the initial payment that is due April 1, 2009, is actually a payment for the year 2008 and, even though it is paid in 2009, the year of waiver, it must still be paid. A second payment is due by the end of 2009, and that payment is waived.
Now, move forward a year. If someone turns 70-and-a-half in 2009, the first payment is due by April 1, 2010. Even though 2010 is not a year of waiver, that payment is waived because it is a payment made (or in this case, waived) with respect to 2009.
The waiver can also be of help to beneficiaries who are receiving distributions from IRAs. Such distributions are often made over a five-year period, beginning in the year after the year of death of the individual who established the IRA. If such a distribution is being made, and 2009 is one of those five years, the payment due in that year can be skipped, and the distribution can extend to a sixth year.
A couple of additional points:
• The waiver does not apply to defined benefit pension plans, nor to payments being made in the form of an annuity.
• Any amount withdrawn during 2009 that would otherwise be required will not be required minimums and, in most cases, will be eligible for rollover. Despite that, employers are not required to withhold 20 percent income tax from such distributions, which would ordinarily be necessary for so-called eligible rollover distributions. But if distributions exceed what would otherwise be the minimum, withholding is required on the excess, certainly a complicated simplification effort.
• Relief is offered in the event that certain IRA reporting requirements are mistakenly carried out disregarding the waiver, since the change in the law took place so late in the year.
The waiver of required minimum distributions can be a valuable relief provision for individuals who have suffered from the recent market downturn, but care is needed to avoid violating the detailed rules governing such distributions. •
Robert H. Louis is a partner and co-chairman of the personal wealth, estates and trusts department at Saul Ewing. His practice includes estate, tax and retirement planning for individuals and closely held businesses. He is a fellow of the American College of Tax Counsel, and a graduate of the Wharton School and the Harvard Law School. Louis can be reached at email@example.com and 215-972-7155.