Wisconsin Lawyer
Vol. 75, No. 10, October 2002

Final Rules on IRA and Retirement Plan Distributions

by Andrew J. Willms & Jason R. Handal

On April 17 the IRS released final regulations under Internal Revenue Code (I.R.C.) section 401(a)(9). Proposed regulations, which were the topic of a September 2001 article in the Wisconsin Lawyer,¹ were issued in January 2001. This article focuses on the final regulations.

The final regulations retain and clarify last year's sweeping changes to the minimum distribution rules pertaining to individual retirement accounts and qualified retirement plans ("retirement accounts"). Prior to 2001, the rules governing retirement account distributions were governed largely by proposed regulations that created almost as many questions as they answered.

Since January 2001 the IRS has solicited comments from attorneys and other tax professionals regarding the 2001 proposed regulations. The final regulations clarify and modify various aspects of the 2001 proposed regulations, in response to comments submitted to the IRS.

Effective Date

The final regulations are effective Jan. 1, 2003. However, for determining 2002 required minimum distributions, taxpayers may rely on the final regulations, the 2001 proposed regulations, or the 1987 proposed regulations.

Updated Uniform Table

The 2001 proposed regulations contained a simple, uniform table to be used by almost all taxpayers when determining the minimum amount that must be withdrawn annually from their retirement accounts during life. The final regulations contain an updated life expectancy table for use in determining required minimum distributions. For example, the distribution period for a person age 70 ½ was increased from 26.2 to 27.4. This will mean smaller required minimum distributions from retirement accounts. The updated mortality tables can be used to determine life expectancy to calculate the amount of substantially equal period payments under I.R.C. section 72(t)(2)(A)(iv).

Determination of Designated Beneficiary

The 2001 proposed regulations provided that determining the rate of distributions could be delayed until Dec. 31 of the year following the account owner's death. The final regulations change the determination date from Dec. 31 of the year following death to Sept. 30 of that year.

The final regulations also clarify that if a designated beneficiary dies after the account owner dies but before Sept. 30 of the year following the account owner's death, the designated beneficiary (and not the successor beneficiary) will continue to be the beneficiary for required minimum distribution purposes. The final regulations provide that if the account owner is married on Jan. 1 of a given year, he or she will be regarded as having been married for the entire year for required minimum distribution purposes.

Disclaimers

Because the final regulations allow for delaying the determination of the designated beneficiary for required minimum distribution purposes until Sept. 30 of the year following the account owner's death, a disclaimer can be used to change the designated beneficiary to a person with a longer life expectancy than the primary beneficiary. I.R.C. section 2518 requires that a disclaimer be made within nine months of the decedent's death in order for the disclaimer to be "qualified." However, the determination date for required minimum distribution purposes falls after the nine-month disclaimer period expires. The final regulations clarify that a disclaimer must be "qualified" to change the designated beneficiary for minimum distribution purposes.

The IRS refused to adopt in the final regulations requests from commentators that if an estate is 1) named as the beneficiary of a retirement account, or 2) would become a beneficiary by operation of law, then the estate's beneficiary could replace the estate as the account beneficiary.

This refusal highlights the need for retirement account owners to review their retirement account beneficiary designations. Failure to carefully consider and designate a beneficiary could lead to the benefits being paid to the owner's estate, with undesirable distribution and income tax consequences.

Trusts as Beneficiaries

The final regulations provide that documentation of a trust as beneficiary must be provided to the plan administrator, IRA custodian, and so on, no later than Oct. 31 of the year following the account owner's death.

Election to Tax Revocable Trust as Part of Estate

The final regulations clarify that a revocable trust's election to be treated as part of an estate under I.R.C. section 645 will not cause the trust to fail to be a qualified beneficiary for purposes of I.R.C. section 401(a)(9), provided the trust continues to be a trust under state law. This is an important clarification that should help avoid conflicts between the trust's income tax planning and the trust beneficiary's ability to receive distributions from the trust over his or her life expectancy.

Separate Accounts

The issue of separate accounts arises in the context of an account owner who has designated multiple beneficiaries. If maximum income tax deferral is desired, then the ability to divide the account after death and allow each beneficiary to use his or her respective life expectancy when determining the amount of the required minimum distribution is essential.

Under the 2001 proposed regulations, it was not entirely clear that this result could be achieved. The final regulations clarify that separate accounts with different beneficiaries can be established both before and after the required beginning date. The separate accounts will be recognized for required minimum distribution purposes after the account owner's death. If the separate account beneficiary's life expectancy is the only factor to be used for determining that person's required minimum distributions, then the separate account must be established no later than Dec. 31 of the year following the account owner's death.

The final regulations fail to clarify when separate accounts can be established if a trust with multiple beneficiaries is the beneficiary of a retirement account. At a minimum, the beneficiary designation must specify that the account is to be divided into separate accounts. Given the uncertainty, it is preferable to divide the IRA into separate IRAs, each with its own individual beneficiary, prior to the account owner's death when it is practical to do so.

Surviving Spouse's Elections

The final regulations indicate that a surviving spouse may elect to treat an inherited IRA as his or her own at any time after the account owner's death, and that the required minimum distribution for the year of death is determined as though the deceased spouse lived the entire year. Further, the surviving spouse (provided he or she is the account beneficiary) must receive the year-of-death required minimum distribution to the extent such amount was not distributed during the owner's life.

The final regulations also provide that a surviving spouse can roll over distributions received from the deceased spouse's IRA, provided such distributions do not constitute required minimum distributions to the spouse.

Guidance for Qualified Plan Administrators and IRA Custodians

The IRS has not yet published procedures for amending qualified plans to reflect the final regulations, though it intends to do so. As for IRA custodians, Rev. Proc. 2002-10 (2002-4 I.R.B. 401) provides guidance on when IRA documents must be updated for the final regulations. You can find 2002-4 I.R.B. 401 at www.irs.ustreas.gov/bus_info/bullet.html.

Remaining Questions

While the final regulations address many important issues, some significant questions still remain, including:

1. Will a direction in a revocable living trust to pay estate taxes on the grantor/account owner's estate still prevent the trust from being a qualified beneficiary? The answer should be no, as long as the taxes are paid before the Sept. 30 determination date.

2. Must a trust that is designated as a beneficiary be a "conduit trust" in order to avoid counting contingent remainder beneficiaries when applying the "look through" rules of Treas. Reg. §1.401(a)(9)-4?² Many commentators believe that use of this type of trust is required to avoid having to consider contingent remainder beneficiaries' ages, regardless of how remote the beneficial interest.³ However, Treas. Reg. §1.401(a)(9)-4, A-1 indicates that members of a class of beneficiaries that is capable of expansion or contraction will be treated as identifiable if the class member with the shortest life expectancy can be identified.

3. Can a "dynasty trust" be a qualified beneficiary of a qualified plan or IRA? We believe the answer to be yes, though other commentators have disagreed.

4. Can the beneficiary of an inherited retirement account designate the beneficiary(s) following his or her death? The answer should be yes; however, the terms of the plan document or IRA adoption agreement must allow for this and thus must be consulted.

Conclusion

The final regulations improve in many ways upon last year's proposed regulations. Taxpayers and their advisers can operate with greater certainty concerning the simplified distribution rules and can plan more effectively to increase an account owner's ability to defer the income tax liability attributable to qualified plan and IRA accounts. The final regulations also remind of the importance of reviewing beneficiary designations and trust documents to ensure that full advantage is taken of the new rules.

To view the entire text of the final regulations online, visit the "estate planning in depth" section of www.estatecounselors.com.

Endnotes

¹ Andrew J. Willms & Jason R. Handal, Simplified Rules on IRA and Retirement Plan Distributions, 74 Wis. Law. 10 (September 2001).

² A "conduit trust" is a trust in which the trustee does not have the power to hold or retain retirement plan distributions inside the trust. Rather, any amount distributed from the retirement account must be immediately distributed to a single trust beneficiary. Although a trust is not a person, and therefore has no actual life expectancy, the "look through" rules allow a qualified trust to use the life expectancy of the oldest trust beneficiary when determining the amount of required minimum distributions.

³ See Priv. Ltr. Rul. 200228025 (July 12, 2002).

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