Taxman softens on distributions for retirees

PERSONAL FINANCE

January 21, 2001|By EILEEN AMBROSE

It doesn't happen often, but the Internal Revenue Service is getting a lot of praise these days.

The reason is that the agency this month proposed rules that significantly simplify taking required distributions from 401(k) and 403(b) accounts, individual retirement accounts and other tax-deferred retirement plans.

For most people, the new rules will lower the minimum amount they are required to withdraw each year, a boon for those who want to reduce their tax bite and let their money grow tax-deferred longer, experts said. The changes also will provide greater flexibility in naming beneficiaries and reduce the risk of making distribution mistakes, experts said.

"These changes are huge. They basically scrap the old regulations," said David Foster, a fee-only financial adviser with Foster & Motley Inc. in Cincinnati. "This is really truly the kindler and gentler IRS."

Besides making distributions easier for individuals, the new rules require more reporting by financial institutions to make it easier for the IRS to ensure that taxpayers are in compliance. The proposed changes are not expected to become final until next year, after public comment. But the IRS said taxpayers can continue using the old rules or apply the new ones for distributions this year.

"Anybody who is now over 70 1/2 should not take distributions this year until they check this out," said Natalie Choate, an estate planning lawyer in Boston and author of "Life and Death Planning for Retirement Benefits." In most cases, she said, retirees will find the new rules offer more favorable treatment than the old ones.

Be aware, Choate said, that those taking distributions from a company plan, such as a 401(k), will have to operate under the plan's rules until they are amended.

The government requires distributions so that it can begin getting tax revenue from all those nest eggs that people have been building up tax-deferred. Withdrawals - including money from investment gains - are taxed as regular income, not as long-term capital gains.

Retirees must begin withdrawing money from traditional IRAs and retirement plans by April 1 of the year after they turn 70 1/2 . (With a Roth IRA, distributions are not required until the owner's death.)

Under the old rules, before retirees took mandatory withdrawals, they had to make decisions that locked in their distributions for life. They had to choose a beneficiary, one of the factors determining how fast a retiree has to draw down the account, and select a method of calculating distributions. The rules were complicated and confusing, experts said.

"They were mind-boggling, even to professional advisers," said Paul Nastasi, a financial planner with A. J. Perry and Co. in Baltimore. Sometimes, Nastasi said, clients would come to him when it was too late to fix mistakes. For example, a 75-year-old client named his estate as his IRA beneficiary, a choice that would require faster payouts and cost heirs potentially huge sums of money over decades when the investments could have grown tax-deferred, Nastasi said.

Tax simplification of distributions is long overdue, Nastasi said. "We can help clients make decisions, but a lot of these decisions require the client to have some understanding of the issues," he said.

IRS officials have gone a long way to fixing the pitfalls, experts said. "They did a really good job to make this foolproof," said Ed Slott, publisher of Ed Slott's IRA Advisor.

Under the new rules, everyone uses the same distribution time-table, which initially assumes that a retiree will live an additional 26 years and is readjusted annually as life expectancy increases. "It keeps stretching out as long as you live. You don't have to take the money out by age 96," Choate said.

There's one exception to the uniform timetable. If a retiree's beneficiary is a spouse who is more than 10 years younger, distributions can be stretched over a longer period, Choate said.

For most people, experts said, the new rules will mean smaller mandatory distributions because the assumed payout period will be longer, no matter their age or choice of beneficiary.

Another major change involves the designation of beneficiaries. A retiree no longer has to name a beneficiary before taking required distributions.

The final determination of beneficiaries can be made as late as Dec. 31 of the year after the retiree dies, Slott said. That gives beneficiaries time to disclaim an inheritance or be cashed out, he said.

Say a retiree named a charity and two children as beneficiaries of an IRA. When the retiree dies, the IRA distribution is accelerated and the children are hit with high taxes, Foster said.

Under the new rules, heirs would have time to make adjustments to create a better tax situation. In this case, the charity could get paid its share before the Dec. 31 deadline and then the children could become the sole beneficiaries with distributions based on their longer life expectancies, Foster said.

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