Tricks and Traps Involving Minimum DistributionsFall 2016 – Articles For Your Benefit
Both pensions and IRAs are subject to required minimum distribution (RMD) rules. These rules are complex and constantly changing, and the complexity presents certain planning opportunities but also some traps for the unwary. Set forth below is a general primer on the RMD rules, as we regularly see issues (i.e., failures) relating to RMDs, which can have unexpected – and adverse – tax consequences.
In most cases, individuals must commence required minimum distributions each year – commencing in the year in which they attain age 70½. In the first year in which the individual attains age 70½, the initial distribution may be delayed until April 1 of the year following attainment of age 70½ (the “required beginning date” or “RBD”). This rule applies to all traditional IRA owners and participants in company sponsored retirement plans who own more than 5 percent of the equity of the employer. Roth IRA owners are not required to take distributions during their lifetimes.
Generally, an individual’s RMD is determined by dividing the adjusted market value of their IRA or employer sponsored retirement account as of December 31 of the prior year by an applicable life expectancy factor taken from the Uniform Lifetime Table. There are special rules for participants in traditional retirement plans and those whose spouses are more than 10 years younger.
Additional Deferrals for Less than 5 Percent Owners
This rule, permitting a delay in the RBD, applies to RMDs from a qualified plan sponsored by an employer for whom an individual continues to perform services for as an employee. It is frequently advantageous to professionals such as lawyers, accountants, architects and others who are likely to reduce or eliminate their ownership interest in their employer as they approach retirement. It can be advantageous to reduce ownership in the employer prior to commencement of the distribution. As long as ownership is reduced to less than 5 percent prior to the date on which distributions are to commence, and the individual remains employed by the employer, distributions can be delayed until the individual terminates employment.
Treasury regulations impose no requirements on the number of hours that must be worked by the employee and the amount that must be paid. Nevertheless, the employment should be a bona fide employment relationship requiring that the employee render legitimate services in exchange for the compensation paid as W-2 income. Individuals who utilize this strategy must take care to properly determine their ownership share, as in situations where the employer is organized as a partnership or an LLC, ownership is determined by the greater of capital or profits interest and it is common for individuals to relinquish capital but still retain a profits interest in the partnership.
An enhancement on this technique involves rollover of IRA and other qualified plan accounts to the plan allowing the participant to delay RMDs, although engaging in such planning should only be done with the advice of professionals experienced in these matters.
Alternate Distribution Tables
While this is not the forum for marital advice, those with spouses who are more than 10 years younger may use a joint life expectancy table to calculate the amount of each distribution rather than using the Uniform Lifetime Table. This will allow the IRA owner or participant to “stretch” distributions over a longer period of time, thereby conserving the largest possible account balance. However, the individual’s spouse must be the sole beneficiary of the account. In general, those designating multiple beneficiaries may not avail themselves of this alternative. One strategy, however, is to divide the IRA in multiple accounts, leaving one IRA with the individual’s spouse as sole beneficiary. When creating multiple accounts, care must be exercised to avoid violating the one rollover per year rule imposed upon IRA accounts. While a full discussion of the rollover restrictions is beyond the scope of this article, it is a trap for the unwary and anyone engaged in a rollover transaction involving an IRA should be mindful of this requirement and, again, this strategy should only be pursued with the proper guidance from experienced professionals.
Distributions From Defined Benefit Plans
Traditional defined benefit plans and cash balance plans follow a different set of rules. Under the rules applicable to such plans, payments must commence as if the individual retired and benefits commenced. The first payment must begin before the employee’s required beginning date. However, the individual may select any form and payment frequency of benefits that is permitted under the plan; once payments have commenced, in general, they must continue until the death of the participant.
One technique to stretch payment is to select an alternate form of benefits such as a “joint and survivor annuity,” which spreads payments over the life expectancy of the participant and his or her spouse. This technique reduces the amount of each monthly payment and keeps the participant’s current taxable income to minimum. Another technique, for plans permitting lump sum payments, is for the participant to select a lump sum payment of the commuted value of his or her pension. Most of this lump sum payment can be rolled over to a defined contribution plan sponsored by an employer in which the participant does not have a 5 percent ownership position. As a rollover account, the remaining amount is treated like a defined contribution plan and can be deferred until the participant ceases employment with the new employer. Once distributions commence, they are treated like any other defined contribution plan and distributions may be made under the defined contribution rules using the appropriate life expectancy table.
This article only scratches the surface regarding the RMD rules and related planning techniques. The distribution rules are highly complex and anyone with significant retirement plan or IRA assets should be thoroughly familiar with them or seek guidance before commencing any distributions.