Understanding the Final Minimum Distribution Rules

The IRS issued final minimum distribution regulations on April 16, 2002. “¶” references in this outline refer to sections of the author’s book Life and Death Planning for Retirement Benefits where more detail on the topic is provided. My thanks to Barry Picker, CPA, and George Coughlin for their comments.

1. New Life Expectancy Tables

As Congress demanded in EGTRRA, the IRS has updated all the life expectancy tables to reflect more current, longer, life expectancies. The new "Uniform Lifetime Table" (see last page of this Supplement) replaces the 2001 regulations' "Uniform Table" (which was the old "MDIB Rule Table"). Reg. § 1.401(a)(9)-9.

2. Designation Date moved up to 9/30 of year after death

The 2001 version of the proposed minimum distribution regulations allowed beneficiaries of a deceased employee or IRA owner until December 31 of the year after the year of the Participant's death to "finalize" the decedent's choice of beneficiary for purposes of determining required distributions, through disclaimers or distributions or possibly other means. The approach of that edition of the regulations was wide open — the designated beneficiary simply was not determined until 12/31 of the year after the year of death.

The final regulations have moved up the "Designation Date" from December 31 of the year after the year of death to September 30 of the year after the year of death, and also taken a narrower approach to what can happen between the date of death and this shortened deadline. The new approach is that the designated beneficiaries are determined as of the date of death. Between the date of death and the Designation Date, you can eliminate a date-of-death beneficiary from the mix by disclaimer or distribution, but you cannot "add a new beneficiary." "In order to be a designated beneficiary, an individual must be a beneficiary as of the date of death...the employee's designated beneficiary will be determined based on the beneficiaries designated as of the date of death who remain beneficiaries as of September 30 of the calendar year following the calendar year of the employee's death." Reg. § 1.401(a)(9)-4, A-4(a).

This means that post-mortem planning options are narrower than some practitioners (including this author) speculated at the time of issuance of the 2001 proposed, minimum distribution regulations — although the IRS may contend the regs are merely clarifying, not cutting back on, what the Service meant back in January 2001. Beneficiaries can be removed by distribution of their benefits, or by qualified disclaimer, but that may be the extent of permitted post-death changes. This puts an end to speculation that an executor or trustee could be given a power to choose a beneficiary after the employee had died. It also, according to the IRS, means that distributing a retirement plan out of an estate or trust to the individual beneficiaries of the estate or trust does not change the "designated beneficiary" to the individuals, because that would be "adding" a new beneficiary.

Trust instruments and beneficiary designations that specifically refer to the December 31 date (including forms in my book) must be reviewed.

3. Separate accounts rule clarified

Reg. § 1.401(a)(9)-8, A-2(a)(2) adds complexity and clarity to the establishment of separate accounts for purposes of required distributions. Separate accounts for different beneficiaries can be established "at any time," but there are several different deadlines by which this separation must occur to be effective for various purposes:

A. For purposes of determining the applicable distribution period, the separate accounts must be established by December 31 of the year after the year of participant's death. Thus, if the account is left equally to three children, the separate accounts should be established prior to 12/31 of the year after death if you don't want all three children to have to use the oldest one's life expectancy to measure MRDs. Presumably, plan administrators, for their own convenience, will use the oldest child's life expectancy for the first year's MRD if the separate accounts have not been established by 9/30 of the year after the death year, and switch to individual life expectancies for subsequent distribution years if the separate accounts are "established" between 9/30 and 12/31 of the year after death.

B. December 31 of the year after the year of participant's death is also the deadline for establishing a separate account payable solely to the spouse for purposes of the special distribution rules applicable to the surviving spouse of a participant who died before his RBD.

C. For purposes of allocating investment gains and losses separately and all other purposes of determining MRDs, the separate accounts can be established at any time. Thus, if the account is left equally to four children, and MRDs are computed using the total account value and the oldest child's life expectancy for the first six years after Participant's death, and in year 6 the children decide to go their separate ways, they can establish the separate accounts in year 6. For year 7 and later years, MRDs will be computed for each child based on his or her separate account balance (but still using the oldest child's life expectancy).

D. In order for separate accounts to be recognized for ANY of the above purposes, the beneficiaries must have separate interests as of the date of participant's death (e.g, "equal shares to my children"); and between the date of death and date of "establishment" of the separate accounts, gains and losses must be allocated pro rata to all the accounts and distributions must be charged to the account of the beneficiary who receives the distribution. Reg. § 1.401(a)(9)-8, A-3. This means that a pecuniary bequest cannot qualify as a separate account unless it will share in profits and losses post-death (which pecuniary gifts usually do not do). The purpose of these requirements is apparently to ward off game-playing whereby scheming beneficiaries would try to shift distributions or investment gains to low income beneficiaries during the post-death cleanup period.

How does the December 31 deadline interact with the requirement that the Participant's designated beneficiaries are determined as of the date of death, and that a beneficiary may be "removed" (by disclaimer or distribution) only until September 30 of the year after death? While the interaction of the various deadlines is not clear in all instances, some points are clear:

First, if there is any beneficiary whom you want "removed" (such as a charity, or an individual who is much older than the other individual beneficiaries) you have two options. If the "bad" beneficiary's interest is in the form of a pecuniary gift, it will not qualify as a "separate account" (unless local law or the governing instrument requires that pecuniary-amount gifts share pro rata with other bequests in post-death gains and losses — which would be unusual). Therefore you must get rid of it (by disclaimer or distribution) before September 30 of the year after the year of death, because it cannot possibly qualify as a separate account.

If the "bad" beneficiary's interest is a fractional or percentage interest, and it is not entirely paid out to the bad beneficiary (or disclaimed by the bad beneficiary) before September 30, the younger individual beneficiaries are still "ok" if the retirement plan benefit is divided into "separate accounts" by the December 31 deadline and the "separate account" payable to the charity or older beneficiary is separate from the "separate accounts" payable to the younger individual beneficiaries.

4. Trust rules

A. Documentation deadline. The new deadline for supplying a copy of the trust to the plan administrator ("Trust Rule" # 4) is October 31 of the year after the year of the participant's death. In the October 31 certification, the trustee certifies who were the beneficiaries of the trust on the September 30 Designation Date. A transition rule specifies that the deadline is extended to October 31, 2003, if that is later than the normal deadline of October 31 of the year after the year of the participant's death. This allows any trust which "passes" all the other trust rules (i.e., the trust rules other than the documentation requirement) an extension of time to 10/31/03 to fulfill the documentation requirement. Reg. § 1.401(a)(9)-1, A-2(c).

B. Separate accounts vs. separate trusts. Trust beneficiaries cannot use the "separate accounts" rule for the trust's interest in the benefits. Reg. § 1.401(a)(9)-4, A-5(c). Three PLRs, 2003-17041, 2003-17043 and 2003-17043 have interpreted the new sentence in the final regulations as meaning that benefits that are payable to a single trust as named beneficiary cannot, under any circumstances, be divided up into "separate accounts" for the beneficiaries of that trust, even if the trust is required by its terms to terminate upon Participant's death and distribute the retirement benefits to separate individual beneficiaries or separate trusts or subtrusts. Thus these PLRs directly reverse the IRS's prior position on this point (compare PLR 2002-34075). If separate accounts treatment is important, therefore, do not make benefits payable to a single funding trust; create the separate accounts in the beneficiary designation form itself (i.e., make the benefits payable directly to the ultimate beneficiaries for whom you want separate account treatment). .

C. Disregardable beneficiaries. The "A-7" rule is reworded: It now says that a beneficiary can be disregarded (for purposes of determining the oldest beneficiary and whether all beneficiaries are individuals) if such beneficiary is merely the successor to the interest of another beneficiary, but cannot be ignored if he/she has his/her own interest in the trust that is not merely as successor to another beneficiary's interest. The Preamble indicates that this is not eliminating, but merely clarifying, the 2001 proposed regulations' version of the rule. This marginal improvement falls short of clarifying the many cloudy issues in this area. There is still:

1. No guidance on generation skipping trusts
2. No guidance on grantor trusts
3. No guidance on a trust which can be accumulated to a certain age such as 30, 35, 40, etc. and then is distributed outright to the beneficiary. While the regs arguably say that the contingent remainder beneficiary of such a trust is merely a "successor" to the primary beneficiary, they can easily be interpreted by an IRS agent as saying that ANY accumulation (even if it ends at an age well within the beneficiary's life expectancy) means you have to "count" the remainder beneficiary.
4. No clarification of the QTIP example in the regs which is extremely unclear and arguably supports the conclusion that you cannot have a non-individual contingent remainder beneficiary under any circumstances, no matter how remote those circumstances may be.

5. Cleanups of the proposed regulations

The final regs clear up several glitches that materialized in the 2001 proposed regs:

A. Death of beneficiary prior to Designation Date does not cause loss of DB status. Under the regulations, a person who is a beneficiary as of the date of death, but then dies prior to the Designation Date, does NOT lose his status as a "designated beneficiary." Reg. § 1.401(a)(9)-4, A-4(c). He will still be considered a designated beneficiary (unless his benefits are entirely distributed to him or his estate, or disclaimed by him or by his executor) prior to the Designation Date. His successor beneficiaries do not step into his shoes as "designated beneficiaries." This change clears up a major problem that existed in the 2001 proposed regulations, namely, the possibility that the death of the beneficiary after the participant but before the Designation Date could cause loss of designated beneficiary status and loss of the life expectancy payout method.

B. Marital status determined January 1 for lifetime distributions. As under the 2001 proposed regs, lifetime MRDs can be determined using the joint life expectancy of participant and spouse if spouse is the participant's sole designated beneficiary for the entire distribution year and is more than 10 years younger than participant. The final regs add: Spouse is considered "spouse" for the entire year if participant and spouse were married to each other on January 1. Spouse is considered "sole beneficiary" if she is sole beneficiary on January 1 and participant does not change his beneficiary prior to the end of the year (or the death of spouse, if earlier). Thus, death or divorce per se does not affect MRDs until the distribution year following the death or divorce. However, if participant changed his beneficiary designation during the year, while spouse was still living, to name someone other than spouse as beneficiary of all or part of the benefits, he would lose the ability to use the joint life expectancy (even if they were divorced at that point). Reg. § 1.401(a)(9)-5, A-4(b)(2).

C. Life expectancy calculations made uniform for participant and spouse. Under the 2001 proposed regs, the method of calculating the remaining life expectancy of a deceased participant was different from the method of calculating the remaining life expectancy of a deceased spouse; now both are the same.

D. Post-RBD Deaths: ADP is LE of DB or P whichever is longer. If Participant dies after his RBD, the Applicable Distribution Period is the remaining life expectancy of the Participant or of the designated beneficiary, whichever is longer. This helps when the designated beneficiary is older than the Participant. Reg. § 1.401(a)(9)-5, A-5(a)(1).

6. Other stuff

A. Switching to life expectancy method from 5-year rule. The regulations offer a limited window for beneficiaries to switch back from using the 5-year rule to the life expectancy payout method by 12/31/03. This is a valuable planning opportunity for beneficiaries of any decedent who died (i) in the years 1997-2001 and (ii) before the RBD, where the beneficiaries may not have qualified (or may not have known they qualified) for the life expectancy payout method, so did not take distributions in the early post-death years, to get back on track with a life expectancy payout.

B. The Preamble to the final regulations discussed adapting the new tables to the "series of substantially equal periodic payments" exception to the 10% penalty for pre-age 59 1/2 distributions. The language in the Preamble (as well as Notice 89-25, A-12, to which it referred) were both subsequently superceded by Rev. Proc 2002-62 issued by the IRS in October 2002. Click here to read about Rev. Proc. 2002-62.

C. New list of what does and doesn't count towards the MRD requirement. This helpful addition confirms that non-taxable distributions (such as NUA) count towards the MRD requirement. Reg. § 1.401(a)(9)-5, A-9; § 1.408-8, A-11.

D. Annuity and DB Plan Rules are issued as temporary and proposed regulations. These sections deserve study as a planning opportunity, since they permit payouts that increase over the years and also a locked in payout period based on the new uniform lifetime table. Reg. § 1.401(a)(9)-6T.

E. Simplification. In computing lifetime required distributions for the second distribution year, the participant will no longer be able to adjust his prior year end account balance downward by the amount of any required distribution for the first distribution year that was postponed into the second distribution year.

7. Effective date issues

The final regs confirm that post-death MRDs are determined under the new regs regardless of when the decedent died. Thus, when determining MRDs from the account of a participant who died prior to the existence of these regs, "the designated beneficiary must be redetermined....and the applicable distribution period must be reconstructed" in accordance with the new rules. Reg. § 1.401(a)(9)-1, A-2(b) (I call this the "exhume-the-body rule"). This creates a new glitch: If beneficiaries of a 2000 decedent had cleaned up the beneficiary designation by 12/31/01, but not by 9/30/01, then they were "ok" under the 2001 proposed regs but would not be "ok" under the 2002 final regulations. Presumably the IRS did not mean to undo valid 2001 post-mortem beneficiary designation cleanups!

Final regs must be used for 2003 and later years for all distributions from all types of plans. There is no "grandfathering" and no ability to elect out. For 2002, distributions can be determined using EITHER the final regs or the 1987 or 2001 proposed regs.

8. Matters requiring additional study

The biggest remaining mess is the trust rules. The IRS needs to follow its own example in other areas of issuing regulations or a notice with numerous clear examples (rather than just two examples one of which is ambiguous). The IRS needs to follow the Congressional and its own example of disregarding interests that have an actuarial value of less than 5% of the total value. The IRS needs to tell us what they are trying to say in the trust rules because it is still not clear.

The effective date rules need further study particularly regarding the calculation of required distributions for years prior to 2003. When you find yourself trying to calculate catch-up distributions and possible penalties for the years 1987 through 2002, you will discover that (1) distributions calculated as provided in the then-proposed regulations are protected, because taxpayers "may rely" on those, but otherwise the only legally binding standard of law for calculating those distributions is (2) "a reasonable interpretation of the statute." The final regulations were NOT issued with retroactive effect; but presumably they can be used to measure pre-2003 distributions because how can the IRS contend that its own regulations do not provide a reasonable interpretation of the statute?

The various deadlines for determining who is the designated beneficiary will still need some hammering out. For instance, the IRS treats a disclaimer as something that occurs between the date of death and the Designation Date, but a disclaimer dates back to the date of death. How does a court action reforming a trust or beneficiary designation fit in? If it is completed by the Designation Date is it given effect for MRD purposes?

It is still not clear whether percentage or fractional interests in an IRA are "automatically" separate accounts as of the date of death, or whether some additional step is required to "establish" these as "separate accounts." It is still not clear to this author, if there are multiple beneficiaries and their interests are NOT treated as "separate accounts," whether each beneficiary has a personal obligation to take a MRD each year, or whether that obligation applies to the account as a whole.

In interpreting the details of the final regulations, keep an eye on the Preamble. In the Preamble the IRS says what they THOUGHT they did, and particularly what they thought they were changing and not changing compared with the 2001 edition.

Estate planning lawyers need to figure out the economic consequences of making retirement benefits payable to a QTIP or credit shelter trust (compared with the economic consequences of making the benefits payable to individual family members). Especially with the new longer life expectancies recognized by the new actuarial tables, the life expectancy payout method becomes more and more attractive financially.

The "Uniform Lifetime Table"

...for determining lifetime required distributions for (almost) everyone

Under the final Minimum Distribution Regulations, the above “Uniform Lifetime Table” may be used by all taxpayers to compute their lifetime annual required minimum distributions for 2002, and must be used for 2003 and later years (for exceptions see below). For each “Distribution Year” (i.e., a year for which a distribution is required), determine:

(A) the account balance as of the preceding calendar year end;
(B) the participant’s age on his or her birthday in the Distribution Year; and
(C) the “applicable divisor” for that age from the above table. “A” divided by “C” equals the minimum required distribution for the Distribution Year. In the age-71½ Distribution Year, do NOT reduce the “A” number by the amount of any required distribution for the age-70½ year that had not been taken out by the end of that year; this adjustment has been eliminated.

This table does not apply to beneficiaries of a deceased IRA owner; or if the sole beneficiary of the IRA is the participant’s spouse who is more than 10 years younger than the participant. This table may not be used for distribution years prior to 2002.

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