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A new set of distribution rules just issued by the IRS
could help your 401(k) savings last you longer in retirement. The new rules also
simplify the previous, complex set of rules about naming beneficiaries and calculating
withdrawals that often confused retirees.
Retirement plans can start using the rules
immediately, the IRS says. That's good news for retirees and workers who currently make
withdrawals or who need to start this year. The only catch is that before employees can
take advantage of these rules, employers must amend their plan documents to include them.
It could take a few months to do that, retirement industry experts say.
The new rules make it less likely that someone will make a
costly mistake when naming a beneficiary and deciding how to calculate minimum withdrawals
from a retirement account. Previously, figuring out how to withdraw money without paying a
bundle in taxes or unwittingly depleting an inheritance often required hiring a battery of
lawyers, financial planners and accountants to interpret the IRS' arcane distribution
rules.
Those rules were altered dramatically on Jan. 12, when the
Clinton administration made a flurry of last-minute executive decisions and rule changes.
With the new rules, "there is more flexibility
for the participants," said David Wray, president of the Profit Sharing/401(k)
Council of America, a trade organization representing employers that operate 401(k) plans.
Who's Affected?
The rules do apply to 401(k) plan participants who
take periodic withdrawals from their accounts after age 70ý. So, if your plan doesn't
permit periodic withdrawals and requires you to take a lump-sum distribution when you
retire, these rules won't apply to you as far as your 401(k) is concerned.
If you roll your 401(k) lump sum into an IRA, however, you
will be affected because these rules do apply to required minimum withdrawals from
IRAs.
These rules don't affect 401(k) and IRA withdrawals
you make before age 70ý. They also don't affect your beneficiaries if you die
before reaching 70ý.
The Changes
In announcing its new rules, the IRS acknowledged that the
old rules were "unreasonably restrictive" and "too complex."
Under the old rules, you had to name your beneficiaries and
select the way of calculating your required minimum distributions by the time you reached
your required beginning date. Your required beginning date is April 1st of the year after
you turn 70ý. The decisions you made then were irrevocable, meaning they affected
your withdrawals for the rest of your life.
The decisions could be simple if you were single and had no
heirs. Yet, if you wanted to leave your nest egg to your children or a charity, it got
complicated. If you made a bad choice, your heirs could be forced to withdraw the 401(k)
balance all at once. This meant they had to pay income tax on the entire amount at once,
plus the balance stopped growing tax-deferred.
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The old withdrawal rules were
"unreasonably restrictive" and "too complex."
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— Jan. 12, 2001
IRS statement.
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Here are highlights of the new rules.
No More Irrevocable Decisions: Probably the most
important change in the new rules is that you gain more flexibility about naming
beneficiaries.
Under the old rules, the choices on record with your plan
custodian when you reached your required beginning date were irrevocable. "Now, you
can change your mind on a regular basis," said Kyle Brown, retirement counsel with
Watson Wyatt Worldwide.
Here's why this is important. Suppose before reaching 70ý
you selected your spouse as your beneficiary and decided to use your combined life
expectancy to calculate your distributions. If you chose the wrong method of calculating
your combined life expectancy and your spouse died first, you might have to increase the
withdrawals from your 401(k) account and drain it faster. Under the old rules, your
distributions would still be governed by a decision that you made earlier but was no
longer valid.
Under the new rules, if your spouse dies first, you can
choose a new beneficiary and use that person's life expectancy.
Easier to Compute Withdrawals: Under the old rules,
when you started taking withdrawals, you had to decide if you were going to use single
or joint life expectancy. You may want to use two life expectancies because it can
help you stretch out your withdrawals. The formula used to calculate two life expectancies
factors in the fact that one person may outlive the other.
You also had to decide if you would use a term certain,
re-calculation or hybrid method of calculating the withdrawals. Further, if you named a
child 25 years younger than you as a beneficiary, you could not take full advantage of the
age difference to stretch out the payments. The biggest difference you could use was 10
years.
Under the new rules, all you need to figure out is if you
will be using a single life expectancy, yours, or a joint life expectancy, yours and your
beneficiary's. But, be aware you can only use a joint life expectancy calculation if you
name your spouse as sole beneficiary.
Here's how it works. Suppose you will turn age 70ý this
year and will need to start taking minimum distributions in 2002. Further suppose you have
a 401(k) balance worth $1 million. You can figure out your required distribution by
looking at the IRS'
new distribution table (page 52) and dividing the account balance by the
"distribution period" on the table.
At age 70ý, the distribution period is 26.2. Divide $1
million by 26.2 and you get $38,168, your required distribution.
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"Now, you can change your mind on
a regular basis."
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— Kyle Brown,
retirement counsel with Watson Wyatt Worldwide.
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If you wanted to stretch out the payments by using a joint
life expectancy, the calculations are still fairly simple. You refer to the joint life
expectancy tables in IRS Publication 590 (page 76).
Suppose your spouse is 55 and you are 70ý. You would
divide the balance by the joint life expectancy distribution period of 29.9, for a
required distribution of $33,445.
The new rules "don't penalize parties with a large age
spread," said Certified Financial Planner George Coughlin, based in Walnut Creek,
Calif.
If you inherit a 401(k) balance, you may also be able to
use your remaining life expectancy to calculate your required withdrawals.
Money Can Last Longer: One of the key changes the
IRS made was replacing the old age 85 life expectancy for a person using term certain
distributions with a new life expectancy table that runs to age 115 and beyond. For
individuals re-calculating their life expectancy, the IRS tables previously ran out at age
110. Translation: The new tables are more generous and you won't be required to drain your
account by age 85.
By lengthening the life expectancy limit, you may now take smaller
withdrawals beginning at age 70ý. That means you'll have more money in your 401(k) to
grow tax-deferred.
"For the vast majority of employees, this new set of
rules means the required minimum distributions can be smaller than under the old set of
rules," Brown said.
You Will Be Told How Much to Take: In addition to
simplifying the calculations, the new rules require your 401(k) custodian or your employer
to tell you how much your required minimum distribution is.
Of course, this also means that your employer or custodian
will have to report to the IRS the amount you are supposed to take. This will make it
easier for the IRS to see if you are trying to avoid paying taxes by not withdrawing the
required amount. The fine for failing to take a required distribution is 50 percent of the
amount that should have been withdrawn.
Beneficiary Choices Can Be Altered After Death:
Under the new rules, beneficiary designations don't have to be finalized until the end of
the calendar year that follows the year of the account holder's death.
Suppose you named your son and daughter as beneficiaries.
But, after you died, only your son really needed the money. Under the new rules, your
daughter could disclaim her benefit. This would mean that your son could take all the
money and base his withdrawals on his life expectancy. This flexibility wasn't permitted
under the old rules.
This rule applies only to beneficiaries named before your
death.
Timing Is Everything
Some of these changes had been talked about for a while,
according to retirement industry experts. The only question was whether they would
actually become law.
The timing of the release surprised the retirement industry
because it happened in the waning days of the Clinton administration. Typically,
last-minute rule revisions include provisions too controversial to release while the
President has a substantial amount of time left in his term.
Still, Dallas Salisbury, president of the Employee Benefit
Research Institute, criticized the government for surprising the industry with the new
rules. "It's a classic example of the government not paying attention to the impact
on the system," he said.
For the most part, this set of rule revisions has received
a favorable review.
"This is a step in the right direction," Wray
said.
For this reason, unlike other last-minute rule changes that
are being criticized by Republicans and businesses, these will probably stand, experts
say.
Yet, the reporting requirement is likely to meet objections
from the financial services industry, Brown said. However, their objections may be
somewhat hollow. While the firms may complain that these rules will add to their
administrative costs, they could be easily offset by the increased fees from clients who
will now be able to leave money in their accounts longer.
Effective Now
The new regulations became effective the date they were
distributed, Jan. 12. Yet, for administrative reasons, it may take months before
your 401(k) plan adopts them as part if its plan document, Wray said. Until that happens,
the rules won't apply to your 401(k) plan.
Further, it's likely that 401(k) plans may not offer as
much flexibility to change your mind on a whim as an IRA account might, Brown said. The
administrative costs to process beneficiary or life expectancy choices may be too high to
allow more than a few changes a year. |
