RECENT DEVELOPMENTS FOR REQUIRED MINIMUM DISTRIBUTIONS FROM RETIREMENT PLANS

By: Thomas J. Murphy

          Since the April 2002 release of the final regulations for required minimum distributions, there have been a number of IRS rulings that attempt to address some unresolved issues.  The following are summaries of these developments together with my interpretations and suggestions.

Rev Rul 2002-62 -- Modifying Substantially Equal Periodic Payments For Sudden Decreases In Account Balance

            This ruling addresses the situation where a taxpayer began receiving pre-59-1/2 distributions from a retirement plan under the fixed "substantially equal periodic payment" provisions of IRC 72(t).  With the drop in the stock market, these fixed payments, based on stock valuations in much better times, can deplete a retirement account within a matter of years.  The most common scenario encountering this problem is a divorced spouse who accessed the retirement funds to supplement a diminished income.  The use of a fixed method allowed for better budgeting since there would not be the year-to-year volatility caused by annually recomputing the year-end account balance. This revenue ruling tries to provide some relief.

OVERVIEW OF APPLICABLE LAW

            Section 72(t)(1) provides for a 10% penalty if a plan participant or IRA owner begins receiving distributions before attaining age 59-1/2.  However, section 72(t)(2)(A)(iv) creates a safe harbor exception to this rule if the payments are part of a "series of substantially equal periodic payments" based on the life expectancy of the owner/participant.  This series of payments cannot be modified for five years after the first payment is received or until attaining age 59-1/2, whichever is longer.

            Notice 89-25 provides for three methods in computing the amount of these payments.  The first one is the similar to the minimum distribution method used for post-59-1/2 distributions.  Each year, the account balance is divided by the owner/participant's life expectancy, using the IRS life expectancy tables.

            The other two methods, the fixed amortization and fixed annuitization methods, allowed for fixed payments that are determined using the account balance when the first distribution was received.  The owner/participant was then locked into this distribution amount for at least five years.   

THE PROBLEM

            With the drastic drop in the stock market, these fixed payments, computed in much better times with much higher account balances, now threaten to exhaust the account balance unless the owner/participants are allowed to lower the distribution amounts.  If a change is made, section 72(t)(4) requires the imposition of the 10% penalty on all funds received up to that point, thereby compounding the problem.  The IRS was under considerable pressure to address this.

THE SOLUTION -- SORT OF

            The revenue ruling tries to solve this problem by creating two special rules.  The main rule says that anyone using the fixed methods can switch to the minimum distribution method without incurring the 10% penalty.  This is an irrevocable, one-time election.  The other, almost comical, rule is that there will be no 10% penalty assessed if the periodic payments cannot be made due to the depletion of the account.

            These two rules apply to any distributions made after January 1, 2003.

STILL, PROBLEMS REMAIN

          While the IRS deserves credit for trying to resolve the situation, many owner/participants will still face difficulties.  The new revenue ruling gives the owner/participant two options.  One is for the owner/participant to continue taking the fixed amount that is more than the plan can accommodate.  The other option is to switch to a lower amount to preserve the account balance but this may be less than what they need to live on.  They cannot later increase this amount without incurring the 10% penalty on everything they have withdrawn up to that point.

OTHER IMPACTS

            The ruling touched on several other aspects of substantially equal payments that have not received much attention.  First, there are some important issues regarding choice of beneficiary and life expectancy.  Under the final regs, it no longer matters who the beneficiary is in determining the minimum required distribution (unless the beneficiary is a much younger spouse).  This ruling provides an exception to this.  The ruling confirms that an owner/participant can use joint life expectancies, to include the beneficiaries, in determining the minimum required distribution.  And it is the actual joint life expectancy.  There is no MDIB requirement that effectively limits the age of the beneficiary to within ten years of the owner/participant.  And the rulings seem to allow for a change in beneficiaries, so that the age of a new beneficiary will be used from that point on.

            Another important aspect is the interest rate cap.  If an owner/participant wants to use a fixed amortized or annuitized amount, the interest rate used cannot exceed 120% of the federal mid-term rate.  This will be almost identical to the section 7520 rate.

            The interest rate cap should eliminate any differences between the two fixed methods.  Prior to the issuance of this ruling, the fixed amortization method used the IRS tables for life expectancy.  The fixed annuitization method, however, could use any "reasonable mortality table".  Typically, this allowed for a shorter life expectancy resulting in higher annual distributions.  This will no longer be the case.

            Finally, the ruling did not change any of the reporting requirements.  Owner/participants will still be required to file a form 4329 with their income tax returns, indicating that the substantially equal periodic payments method is being used.

TAM 200247001 -- No discount for taxes payable by beneficiary of retirement plan.

            A really creative tax planner at work, here.  A personal representative sought a discount on the form 706 for monies held in a retirement plan.  The PR reasoned that the valuation of the retirement plan for estate tax purposes should factor in the taxes that will be subsequently paid on the account.  The PR analogized the case to Eisenberg v. Commissioner, 155 F3d 50 (2^nd Cir, 1998), which allowed for a discount of built-in gains in the valuation of a closely-held corporation.

            The writer of the TAM disagreed and would not allow a discount, citing Robinson v. Commissioner, 69 TC 222 (1977), in which no discount was allowed for the possible income taxes payable on a promissory note.

The PR also sought a discount for lack of marketability, emphasizing that an IRA cannot be transferred or assigned.  Again, and not surprisingly, the IRS disagreed, pointing out that this problem can be alleviated by withdrawing funds from the IRA and then transferring or assigning those funds.

PLRs 200235038 -- 200235041 -- Problems with naming trusts as beneficiaries of retirement plans.

            These four PLRs, which deal with four beneficiaries of the same IRA, exemplify the problems with naming trusts as beneficiaries of retirement plans.

            A trust was the beneficiary of an IRA.  The trust provided 25% would pass to decedent's brother with the residue passing to the decedent's three children in equal shares.  The trust provided that the brother's shares would be distributed outright with the children's shares to be further held in trust.  The question submitted to the IRS regarded which life expectancy could be used for computing minimum distributions to the children. 

            Under the final regs, this is a problem since the life expectancy of the oldest trust beneficiary must be used.  The beneficiaries took some steps to avoid having to use the life expectancy of the oldest trust beneficiary (resulting in using the shortest life expectancy and increasing the amount of the required minimum distribution).  They created four sub-accounts, one for each beneficiary and each with separate accountings and TINs. 

            Without given its reasoning, the IRS ruled that the children had to use the life expectancy of the oldest child, which will increase and accelerate the minimum distributions that the beneficiaries were trying to avoid. 

But it could have been worse.  It is not clear why the life expectancy of the decedent's brother was not considered.  Presumably, he was much older than the decedent's children.  Also, the trust gave each beneficiary a limited power of appointment that was limited to the appointment to individuals younger than that particular beneficiary.  This was smart planning by avoiding the life expectancy of an older beneficiary.  Yet, there was still a problem.  The concern was that, if the power was not exercised, then the default takers would be the surviving children of the beneficiary who cannot be determined until the beneficiary's death.  This uncertainty as to the identity of all trust beneficiaries threatened the trust's special status as a "designated beneficiary" and could have resulted in a much shorter, 5 year payout period.  However, the IRS apparently did not have a problem with this although it is not specifically addressed in the rulings.

PLRs 200248030 & 200248031 -- Separate accounts within IRAs

            These rulings, dealing with two beneficiaries of the same IRA, confirmed the provisions in the final regs regarding separate accounts in and IRA that are timely established post-mortem. 

The final regs are unclear as to whether separate accountings are sufficient or whether the IRA must be divided into separate accounts for each beneficiary.  These rulings do not address this specific issue since, in these rulings, separate accounts had already been established.  Until this uncertainty is resolved, the separation of accounts as done here is the safer method.

Notice 2003-3 -- Reporting MRDs from IRAs

            This notice largely confirms the new reporting requirements for IRA custodians regarding minimum required distributions.  There are two alternatives.  One alternative is to provide a statement to the IRA owner stating that a distribution is required and the date by which the distribution must be taken.  The custodian must also make an offer to compute that amount if asked to do so by the IRA owner.  The second alternative is to compute the amount without first being asked.  Beginning January 31^st, our clients will receive these notices on form 5498, entitled "IRA Contribution Information".  (And, undoubtedly, our clients will have questions since the forms are a misnomer -- they should read "IRA Distribution Information".)

            The only real news here is that the custodian does not have to use the same method for all IRA owners and that the notices can be sent electronically.

Rev Proc 2003-13 -- "Deemed" IRAs

            I expect we will start to hear a lot about the new "deemed" IRAs that took effect January 1, 2003.  Employers are now authorized to establish traditional or Roth IRAs for their employees that will be allied to their existing qualified plans.  The attraction of the "deemed" IRAs is that employee contributions are not subject to many of the ERISA requirements.  For instance, they will not be subject to the coverage, non-discrimination and vesting requirement applicable to qualified plans.  This, together with the "catch-up" contributions for those over 50 years of age, will allow for contributions over and above what ERISA would normally allow.

            The significance of this ruling is in the sample amendment that calls for the IRA to be held in a trust or annuity separate from the qualified plan trust.   However, the statute, IRC 408(q), appears to permit deemed IRAs to be held in a separate account within the same trust.

Rev Proc 2003-16 -- Hardship rollovers

            The IRS has always been excruciatingly strict about 60-day rollovers.  But with EGTRRA came the enactment of IRC 408(d)(3)(I) that permitted the IRS to waive the 60-day rollover requirement "where failure to waive such requirement would be against equity and good conscience".  This Rev Proc sets forth a non-exclusive list of factors that the IRS will consider when asked to waive the 60 day requirement.  They are: 1) errors by a financial institution, 2) death, disability, hospitalization, incarceration or postal error, 3) how the funds were used (ie, whether the check was cashed or misplaced) and 4) the amount of time that has elapsed since the distribution was made.

            The ruling also allows for an automatic waiver if the problem resulted from bank error if the correction is made within one year of the deposit.

            This ruling will apply to all distributions made after December 31, 2001 (not 2002).

PLR 200304037 -- Surviving spouse as trust beneficiary can do rollover

            This PLR allows a surviving spouse who is the grantor/beneficiary of an A/B trust to rollover a retirement plan into an IRA when the spouse is the primary beneficiary of the trust.  Here, the trust had a typical A/B provision with the surviving spouse/trustee having complete discretion as to the funding of the sub-trusts.  This PLR allowed the spouse/trustee to allocate the retirement funds to the surviving spouse's subtrust and, in turn, distribute those funds into an IRA held in the name of the surviving spouse.  This is allowable as long as the spouse is the primary beneficiary of the trust. 

            No real news here since this PLR follows a long line of cases allowing this maneuver when the surviving spouse is the sole beneficiary of decedent's probate estate (rather than, as here, the trust estate). See, most recently, PLR 200304038.

            For Mr Murphy's explanation of the final regulations for minimum distributions for retirement plans, see "The New and Final Regulations for Minimum Distributions From Retirement Plans -- The 15 Essential Points" in the August 2002 edition of NAELA News.

            Thomas J. Murphy is a sole practitioner practicing in the Ahwatukee section of Phoenix.  He can be reached at 480-838-4838 or at tom@murphylawaz.com.