Many professionals, in looking toward their retirement years, puzzle over how to plan for their mandatory IRA distributions; they ask us to explain the rules “in plain English.” Readers should realize, however, that these rules are technical and extremely complex. Any “plain English” summary will not be reliable as a guide to actually making all your IRA decisions.
So it is a good idea to do some serious study or else hire competent advisors for making decisions about beneficiary designations and methods of computing your distributions, because some of the decisions are irreversible. That having been said, here’s our summary.
You may remove money from your IRAs any time, but if you do so before age 59 1/2 there will be penalties for premature withdrawals unless you comply with strict rules regarding “substantially equal” distributions. Any time you take money from your IRAs (here we are not referring to Roth IRAs) you will incur a current income tax obligation. But if you don’t need the money, you may let all your IRA money compound free of current income taxes until April 1 of the year after the calendar year in which you turn 70 1/2. That is the day called your RBD (required beginning date).
Here’s an example: If your 70th birthday is on July 15, 1998 you will be 70 1/2 on January 15, 1999. That means you must begin taking withdrawals by April 1, 2000 (April 1 of the year after the calendar year in which you turn 70 1/2). However, if you do wait until April 1 of the year 2000, that distribution will be you 1999 distribution. This means you will have to take a second distribution in 2000 to be your year 2000 withdrawal; since that might pop you up into the next highest tax bracket, it might be worth your while to take that first distribution in 1999.
How much do you have to take out? Well, that depends on your age and the age of your beneficiary and which of the acceptable methods of calculation you elect. Actually, the very definition of “beneficiary” is one of those technicalities that can’t be adequately covered in a summary like this. Suffice it to say that if your estate or a revocable trust are beneficiaries of your IRA, rather than a specific person, it could result in higher mandatory distributions and accelerated distributions upon your death.
The general idea is that you will make distributions based on life expectancy…either the life expectancy of a person your age or the combined life expectancy of two people the ages of you and your designated beneficiary. Here’s a typical example. A husband age 70 is the IRA owner and his wife age 67 is the designated beneficiary. Their joint life expectancy, using the approved tables, is 22. The first year’s mandatory distribution is the IRA value (at the prior year end) divided by 22. So if the IRA had $200,000 the first year’s distribution must be at least $9,091.
Sometimes a beneficiary is much younger than an IRA owner (a grandchild, for example). If you went to the join life expectancy tables in this situation you would get a very large divisor (a very small mandatory distribution). The IRS has anticipated your ingenuity and made a rule that if there is more than 10 year difference in the two ages, you must go to a special table called the MDIB tables to get your divisor. This table is based on joint lives of two people ten years apart in age. However, if the beneficiary is the spouse of the IRA owner, you can use the actual joint lives tables.
What about minimum distributions in the second year and subsequent years? That depends on whether you elect to use the “term certain” or “recalculation” methods. Whichever you choose is a permanent election. Term certain means that each year you add 1 to your divisor. If your first year distribution was calculated by dividing by 22 (as in the previous example), in the second year you would divide by 21. The following year, you divide by 20 and so forth.
If you use recalculation, then each year you go back to the tables to see what the life expectancy is, either for the owner or for the owner and beneficiary. Using recalculation will produce a smaller mandatory distribution in years after the first year, because every year life expectancy declines by less than 1, so your divisor will be rising more slowly than with the term certain method. Don’t you just love the government for dreaming this up for you?
If the recalculation method means a smaller mandatory distribution, why would anyone elect the term certain method? Usually it is for this reason: if joint life expectancy is being used, and the beneficiary dies, the owner who is using recalculation will then have to recalculate using the life expectancy of just one life…which would mean a much higher mandatory withdrawal. If he or she had been using the term certain method, they would continue adding one to the previous divisor every year.
And don’t forget we are talking about the minimum mandatory distributions. You can always take out more if you want to. However, even if you take out more than you have to in a given year, you cannot count it toward a future year’s minimum. Each year stands alone in that regard.
What happens when the IRA owner dies. This is where the rules get really complicated. Generally, it is possible for beneficiaries to continue to make minimum distributions from the IRA over a number of years to keep getting some advantage from the tax deferral status. However, we take a serious risk of misleading readers if we try to make a brief summary of the rules. Instead let me recommend a terrific book by a real expert and repeat our suggestion to get some experienced guidance from a retirement specialist. (We offer this service to clients of Financial Advantage, of course.) The book is “A Professional’s Guide to the IRA Distribution Rules” by Seymour Goldberg, CPA, MBA, J.D. It is published by The Foundation For Accounting Education (3rd edition, 1997).
J. Michael Martin, J.D., CFP is founder and president of Financial Advantage, Inc., Columbia, MD., fee-only-advisors to retirees and small business owners. He may be reached at 410/715-9200.