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Planning Opportunity Deadline Looms For Beneficiaries Of Inherited IRAs

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A special planning opportunity for beneficiaries of inherited IRAs will be expiring soon. It comes from an exception built into the final required minimum distribution (RMD) regulations adopted in 2002. Beneficiaries who opted into the five-year rule, whether by accident or on purpose may, if the IRA allows it, switch to a lifetime payout, provided they take the proper steps before Dec. 31, 2003.

Until January 2001, the proposed RMD regulations were highly complex. New, simpler regulations were proposed in 2001 and finalized in 2002.

It appears that the authors of the regulations were concerned that many beneficiaries, especially those who had to begin taking distributions while the rules were in a state of flux, might have defaulted into the five-year rule merely due to confusion surrounding the requirements, rather than as a result of an actual desire to delay distributions under that rule.

Therefore, the final regulations included a special, limited time rule for any beneficiary who is subject to a five-year rule, and it doesnt matter whether he affirmatively elected to follow the five-year rule or ended up there under a default provision.

Generally, this opportunity affects any nonspouse beneficiary who is taking distributions from an inherited IRA under the five-year rule. The five-year rule requires that the entire account balance be distributed by Dec. 31 of the fifth year after the decedents death. Thus, if your client is the nonspouse beneficiary of an IRA of a decedent who died between Jan. 1, 1998 and Dec. 31, 2001, and he or she has not yet begun receiving distributions, or if the distributions he or she received did not begin until after Dec. 31 of the year after death, he or she will be affected by this rule. Note that different (more flexible) rules apply to spouse beneficiaries.

The beneficiary can switch to the life expectancy method by taking a distribution before Dec. 31, 2003, of the amounts he would have been required to receive had he initially elected a life expectancy payout. Depending on the amounts involved, this could mean a bit of a tax bite for 2003, but the long-term effect is likely to be significant.

Example: Sylvia Pujoli was named as sole beneficiary of her fathers IRA when he died in 2000. Had she elected a lifetime payout, her first distribution would have been required by Dec. 31, 2001, but she did not take any distributions in 2001 or 2002. Sylvia can wait until 2005 and take the entire remaining account balance in that year if she wishes. But if she takes the distributions that would have been required in 2001 through 2003 on or before Dec. 31, 2003, she can continue the lifetime payout for her remaining life expectancy.

Assume Sylvia was 34 when her father died and that he had $250,000 in his IRA. Sylvias life expectancy in 2001, based on her age of 35, was 48.5 years. If the account balance at the end of 2000 was $250,000, Sylvia would have to take $5,155 for 2001. For her 2002 distribution, assume the account balance on Dec. 31, 2001, was $256,000. Sylvias life expectancy drops by one to 47.5 years, and she must receive a distribution of at least $5,389. Finally, assume at the end of December 2002, the account value was $260,000. Sylvias 2003 distribution amount would be $5,591.

Under this fact pattern, assuming Sylvia currently has received no distributions since her fathers death, she would have a choice: She can take nothing now, nothing next year, and the entire account balance in 2005, triggering a huge tax liability at a higher rate, or she can take $16,135 in 2003 and then continue a lifelong payout over her 45.5-year remaining life expectancy, deferring income taxes for decades.

Note that Sylvia, as a nonspouse beneficiary, simply reduces her life expectancy by one each year, rather than going back into the life expectancy table and obtaining a new life expectancy each year. (This rule appears in the final regulations at Treas. Reg. ‘ 1.401(a)(9)-1, A-2(b)(2).)

April K. Caudill, J.D., CLU, ChFC, is managing editor of Tax Facts and ASRS, publications of the National Underwriter Company. She can be reached via e-mail at [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, October 24, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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