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Planning for the boomer generation’s lifetime required minimum distributions—Part I

A torrent of money has started to flow from the IRAs and qualified plans used by over 77 million U.S. baby boomers to save for retirement. A portion of the first cohort of boomers, the approximately 3.4 million born in ’46, will attain age 70 1/2 this year and will have to begin taking required minimum distributions (RMDs) from their retirement plans. And the money flow from retirement plans and IRAs holding trillions in assets will accelerate in coming years, as the 3.8 to 4 million boomers born annually after ’46 and before ’65 attain age 70 1/2. This 3-part Special Study, an overview of lifetime RMDs, is designed to help tax practitioners and their boomer clients cope with this important financial and tax event—the onset of mandatory distributions from their traditional IRAs and qualified plans.

This article, the first installment, explains when RMDs must commence, choices for first and second year required distributions, and how to satisfy the RMD rules. The second installment of this article will focus on calculating lifetime non-annuity RMDs. The third installment will cover lifetime RMDs from multiple IRAs, the potential role of qualified charitable contributions, and withholding on RMDs.

When Must RMDs Commence?

For IRA owners. The required beginning date (RBD) for an IRA owner–i.e., the date that RMDs must commence—is April 1 of the year following the year in which the owner attains age 70 1/2. (Code Sec. 401(a)(9)(C)(i)(I); Reg. § 1.408-8 , Q&A 3) A person reaches age 70 1/2 as of the date that is six calendar months after the 70th anniversary of his birth. (Reg. § 1.401(a)(9)-2, Q&A 3)

RIA illustration 1: If a taxpayer’s 70th birthday is June 30, 2016, he will reach age 70 1/2 on Dec. 30, 2016, and his RBD is Apr. 1, 2017. If the taxpayer’s 70th birthday is July 1, 2016, he will attain age 70 1/2 on Jan. 1, 2017, and his RBD will be Apr. 1, 2018. (Reg. § 1.401(a)(9)-2, Q&A 3)

For qualified plan participants. A participant in a qualified retirement plan (e.g., 401(k) plan) must begin taking distributions by Apr. 1 of the calendar year following the later of the year in which he: (a) reaches age 70 1/2, or (b) retires (except for 5% owners, who are subject to the same rules as IRA owners). However, note that a qualified plan may provide that the RBD for all employees (including non-5% owners) is Apr. 1 of the calendar year following the calendar year in which the employee attains age 70 1/2. (Code Sec. 401(a)(9)(C); Reg. § 1.401(a)(9)-2, Q&A(e))

Unique deferral maneuver for company owners. A taxpayer may be employed by one company in which he is a 5% owner and another in which he is not. In PLR 200453015 and PLR 200453026, IRS said such a taxpayer could defer RMDs past age 70 1/2 from the plan sponsored by the company in which he was a 5% owner by rolling over his account balance to the plan maintained by the company in which he was not a 5% owner (assuming the latter plan accepted such rollovers).

In approving this result, IRS pointed to Reg. § 1.401(a)(9)-7, Q&A 2. That reg provides that where amounts are distributed by one plan and rolled over to a receiving plan, “the benefit of the employee under the receiving plan is increased by the amount rolled over for purposes of determining the required minimum distribution” for the year following the year in which the amount rolled over is distributed. IRS’s interpretation of this rule is that the amount rolled over is subject to the receiving plan’s RMD rules in the calendar year immediately following the calendar year in which the amount was distributed.

RIA recommendation: An employee who is not a 5% owner may belong to a plan that uses the statutory RBD rule. If he keeps working past age 70 1/2, and is interested in deferring retirement plan payouts, he should not roll over funds from his company plan to an IRA. Under the logic of PLR 200453015 and PLR 200453026, after the rollover, the funds will be subject to the RBD rule for IRAs, not the “deferred” statutory RBD rule for plan participants.
RIA observation: Deferring distributions from a qualified plan will result in a lower current tax bill, a longer-lived tax shelter for the family, and potentially larger payouts for the owner’s beneficiaries.
RIA recommendation: The logic of PLR 200453015 and PLR 200453026 also can be used to a taxpayer’s advantage if he has IRA holdings, and works past age 70 1/2 for a company whose qualified plan uses the statutory RBD rule and accepts rollovers from other plans. In this instance, the taxpayer can defer RMDs from his IRAs by making an IRA-to-qualified-plan transfer. The IRA funds flowing into the qualified plan should be subject to that plan’s deferred RBD.

Choices for First and Second Year Required Distributions

Although the RBD is April 1 following the year in which the IRA owner attains age 70 1/2, the first distribution calendar year is the year in which the IRA owner attains age 70 1/2. (Reg. § 1.401(a)(9)-5, Q&A 1(b)) An IRA owner may postpone the RMD for the first distribution calendar year—i.e., the first calendar year for which a RMD is required—until the second distribution year (i.e., make the first RMD by April 1 of the second year). However, taking advantage of this 3-month “grace period” does not absolve the IRA owner from making a RMD for the second distribution calendar year, on or before December 31 of that second year. (Reg. § 1.401(a)(9)-5, Q&A 1(c)) And even if the first RMD is delayed until the second distribution year, the amount of the required distribution is based on the value of the IRA or qualified plan account at the end of the year before the first distribution year.

RIA illustration 2: Becky attains age 70 1/2 in 2016 and will be 71 on Mar. 1, 2017. She owns a traditional IRA that had a value of $1 million on Dec. 31, 2015. Her RMD for 2016, the first distribution year, is $36,496.35 ($1 million ÷ 27.4, the life-expectancy factor from the Uniform Lifetime Table, explained in the second installment of this multi-part article) for an individual who is 70 (Becky’s age at her birthday in 2016). She may delay taking this distribution until as late as Apr. 1, 2017, but even if she delays taking the 2016 RMD until 2017, Becky still must take a RMD for 2017. If she does not take the first distribution in 2016, and the value of her IRA is $1,040,000 on Dec. 31, 2016, her RMD for 2017 is $39,245.28 ($1,040,000 ÷ 26.5, the factor from the Uniform Lifetime Table for an individual who is 71). As a result of delaying taking her first distribution until 2017, Becky must take a total IRA distribution of $75,741.63 in that year ($36,496.35 for the 2016 required distribution, and $39,245.28 for the 2017 required distribution).

Similar rules apply to first and second year distributions from qualified defined contribution plans (e.g., 401(k) plans).

Consequences of delay. Delaying taking the first year’s RMD until the second distribution year could result in:

1. All or part of the first distribution being taxed at a higher rate than it would have been taxed at if distributed in the first year.
RIA observation: Taxpayers may have an additional tax incentive—namely, state tax savings—for not waiting until the second distribution year to take their first year’s RMD. By waiting, they could lose part or all of the benefits of a state pension/retirement income exclusion for the first distribution year.
2. Some or all of the taxpayer’s qualified dividends and/or net capital gains being taxed at 15% rather than 0% (or, being taxed at 20% instead of at 15%).
3. Reduced deductions and/or credits subject to an AGI floor, such as the deduction for medical expenses, the deduction for casualty losses, and the personal exemption phaseout (PEP) and the itemized deduction (Pease) limitations.
4. A 3.8% surtax on the taxpayer’s net investment income. This surtax applies to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for marrieds filing a separate return, and $200,000 for other taxpayers). For surtax purposes, investment income does not include distributions from IRAs or qualified plans. But MAGI does include distributions from IRAs or qualified plans, including, of course, RMDs.

When to defer the first distribution until the second distribution year. In some cases, it may be advisable for the IRA or qualified plan account owner to delay taking the first RMD until the second distribution year. This may be the case if:

…The taxpayer expects to be in a lower tax bracket in the second distribution year, for example, he retires in the first distribution year and thus will have much lower taxable income from non-retirement-plan sources in the second tax year.
…Taking two distributions in the same year won’t cause any part of the total distribution to be taxed at a higher rate than it would be taxed at if the distributions were taken in separate years. By deferring the first distribution to the second distribution year, the distributee can continue to earn tax-deferred income for a longer period of time.
…If the account owner expects to have less income from other sources in the second distribution year, even if he is in the same tax bracket in that year, deferring the first distribution to that year may enable him to avoid or minimize AGI limitations in the first distribution year without causing any increase in those limitations in the second distribution year. For example, suppose an IRA owner continues to work until after age 70 1/2 and has unreimbursed business expenses in the year he retires. By delaying taking the first distribution until the second distribution year, AGI for the year of retirement will be reduced, and more of the unreimbursed business expenses may be deductible as a miscellaneous itemized deduction.
…Taking the first year’s RMD will cause the taxpayer’s MAGI to exceed the threshold amount that triggers the 3.8% surtax on NII, but deferring the distribution until the following year will not have the same effect because his income from other sources will be much lower.

How to Satisfy the RMD Rules

No later than the RBD, the taxpayer must either withdraw the entire balance in his traditional IRA or begin receiving annual RMDs in one of four ways. RMDs may be made over:

1. the life of the IRA owner;
2. the life of the IRA owner and his designated beneficiary;
3. a period of time not extending beyond the IRA owner’s life expectancy; or
4. a period of time not extending beyond the life expectancy of the account owner and his designated beneficiary. (Code Sec. 401(a)(9)(A); Code Sec. 408(a)(6); Reg. § 1.401(a)(9)-2, Q&A 1)
RIA observation: The overall purpose of these distribution rules is to make sure that IRAs are used primarily for the owner’s retirement, rather than as a tax-sheltered nest egg for the family. To enforce this rule, Code Sec. 4974 levies a 50% penalty on the amount that should have been withdrawn under the RMD rules, less the amount that actually was withdrawn. However, the penalty may be waived if the shortfall in the distribution was due to reasonable error, and reasonable steps are being taken to remedy it.

Qualifying annuities. The first and second payout methods are satisfied if the taxpayer uses his IRA balance to purchase a qualifying single- or joint-life and survivor annuity (e.g., from an insurance company), or takes a qualifying annuity from his employer-sponsored retirement plan. (Reg. § 1.401(a)(9)-6)

Qualifying longevity annuity contracts (QLACs). Taxpayers who are participants in Code Sec. 408 individual retirement annuities and accounts (IRAs), qualified defined contribution plans, Code Sec. 403 plans, and eligible governmental Code Sec. 457 plans may purchase deferred longevity annuities. These life annuities start at an advanced age—as late as the first day of the month after the taxpayer’s 85th birthday. These deferred longevity annuities can provide a cost-effective solution for taxpayers willing to use part of their retirement savings to protect against outliving the rest of their assets. They can also help taxpayers avoid overcompensating by unnecessarily limiting their spending in retirement.

To be considered a valid distribution method under Code Sec. 401(a)(9), a deferred longevity contract must be a QLAC, i.e., one that satisfies the detailed requirements carried in Reg. § 1.401(a)(9)-6, Q&A 17, and Reg. § 1.408-8, Q&A 12. In the IRA context, in order to constitute a QLAC, the amount of the premiums paid for the contract under an IRA can’t exceed $125,000. Also, the amount of the premiums paid for the contract under an IRA on a given date generally can’t exceed 25% of the sum of the account balances (as of Dec. 31 of the calendar year before the calendar year in which a premium is paid) of the IRAs (other than Roth IRAs) that an individual holds as the IRA owner. (Reg. § 1.408-8, Q&A 12)

Annual distributions over a uniform life expectancy table. The third and fourth distribution methods, which call for nonannuity payouts over the anticipated lifespan of the IRA owner or the IRA owner and a beneficiary, require calculations to be made annually to determine each year’s RMD. In most cases, the RMD is determined using a uniform life expectancy table (covered in the second installment), except where the IRA owner’s sole beneficiary is a spouse who is more than 10 years younger than the owner (in this case, a special life expectancy table is used).

RIA recommendation: Well before their RBD for distributions, taxpayers should take a detailed look at their overall financial situation and decide what their goals are for the assets parked in their IRAs and qualified plans. For example, taxpayers whose beneficiaries (e.g., children or grandchildren) are well-off or are otherwise provided for may consider taking the bulk of lifetime distributions in the form of annuities (and QLACs) to maximize retirement income. Those with substantial pension income from employer-sponsored qualified retirements, and who have beneficiaries who will need a hand down the road, may consider the standard lifetime RMD approach for their IRAs and defined contribution plans. Unless they beat the actuarial odds, their beneficiaries will be left with tax-sheltered money in IRAs and/or defined contribution plans when the account owner dies.
RIA recommendation: Before their RBD for distributions, taxpayers also should consider whether the beneficiary designations they made years ago—sometimes decades ago—for their IRAs and defined contribution qualified plans are still relevant.

Beneficiary designations don’t affect lifetime distributions (unless the beneficiary is the taxpayer’s spouse who is more than 10 years younger than the taxpayer, in which case a special distribution table is used). However, beneficiary designations can lock in how account balances remaining at the taxpayer’s death will be distributed.

If an IRA owner dies after his RBD, and had designated a nonspouse beneficiary for the account, the balance remaining in the IRA is paid out over the longer of: (1) the remaining life expectancy of the designated beneficiary, using his attained age in the year immediately following the year of the IRA owner’s death; or (2) the remaining life expectancy of the IRA owner, using the owner’s attained age in the year of his death. (Reg. § 1.401(a)(9)-5, Q&A 5) In either case, the life expectancy is found using the single life table carried in Reg. § 1.401(a)(9)-9, Q&A 1. (Reg. § 1.401(a)(9)-5, Q&A 6)

RIA illustration 3: An IRA owner dies at age 85. If his beneficiary is a 59-year-old child, the IRA account balance at the owner’s death may be paid out—and the tax-shelter of the IRA may be continued—over the beneficiary’s 26.1-year life expectancy.If the beneficiary is a 25-year-old grandchild, the account balance at the owner’s death may be paid out—and the tax-shelter of the IRA may be continued—over the beneficiary’s 58.2-year life expectancy.
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