Essential Planning for Retirement Distributions

For many people, their largest financial asset will be the balance in their retirement plan.  The growth in 401(k) plans and the increases in the limits on deductible contributions to retirement plans have resulted in growth of such plans to overall levels of trillions of dollars.  This growth has generated a number of issues, but a requirement covering all such plans and raising many issues is the necessity of taking withdrawals from such plans beginning at a specified age and at a specified rate.

Why are there such rules, called minimum distribution rules and imposed by Section 401(a)(9) of the Internal Revenue Code, and a mountain of IRS regulations? The ability to deduct contributions to such plans causes a loss of tax revenue to the Treasury, and they want the money back…eventually. The longer the wait to get the lost tax revenue, the less value it has to the Treasury. So the specified age for beginning distributions is 70.5, and the rate can be over life expectancies or a specified number of years. The failure to comply with these rules can result in a penalty of 50 percent of the amount that should have been taken out but was not.  This creates a powerful incentive to take distributions as required by law.

But the rules are complicated, and it’s easy to make mistakes and to forget to take distributions when they are required. This is especially true when the plan owner dies and leaves the remaining benefits to family members. The naming of individuals as beneficiaries, or trusts for a group of beneficiaries, or separate trusts for each beneficiary can lead to different requirements for minimum distributions. Several books have been written on the subject of retirement plan distributions, and even they don’t cover every situation. 

In private letter rulings, the IRS responds to inquiries by and on behalf of taxpayers. The responses they give are to the particular taxpayer and fact pattern, and they cannot be relied upon as authority for other transactions. Despite this limitation, they are useful in showing the thinking of the IRS on difficult tax questions. A recent private letter ruling, No. 200811028, illustrates a solution to a problem of late distributions. In this ruling, a decedent’s IRA was left to a beneficiary. The IRA indicated that distributions were to be made to the beneficiary over his life expectancy, unless he elected a faster payout over five years. The beneficiary did not make such an election, but he also forgot to start taking distributions over his life expectancy. Those distributions should have begun a year after the year of death of the IRA owner, and the first few payments were missed.  When this error was discovered, the beneficiary caught up on the late payments, and he paid the 50 percent penalty tax on the late payments. The IRS ruled that he could continue payments over his life expectancy, enjoying the stretched-out deferral of tax, despite having missed the first few payments. In effect, the IRS said that the failure to take the necessary payments was not an election of the shorter five-year payout method. 

The lesson of this private letter ruling, and many others on the subject of required minimum distributions, is that considerable care is needed in choosing how and when retirement benefits are to be paid, especially to beneficiaries. But if the distribution process gets off to a rocky start, there are some techniques available to preserve the favorable tax treatment for retirement distributions.

Robert H. Louis
Saul Ewing

Explore posts in the same categories: Robert H. Louis, Trusts and Estates

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