Your nest egg just got bigger

New regulations allow slower withdrawals, meaning more tax-deferred gains and less risk of depleting your assets. Inheritance rules have eased, too.

By Brad Burg
Senior Editor

Maybe there's a tax fairy, after all. Early in January, while the rest of us were probably wondering which resolution to break first, something magical happened at the IRS—and now, the money in your qualified retirement plan or IRA is much more likely to last throughout your retirement. You can better protect what's left for your heirs, too.

What happened? The rules for making withdrawals from your plans were eased. Before the changes, those rules were inflexible, and tricky enough to make strong tax lawyers weep—well, complain, anyway.

Worse, they put some retirees at financial risk. At age 70 1/2, a retiree's withdrawal schedule became fixed. It was based on two life expectancies—his and his beneficiary's—plus one of three complicated formulas. From then on, his withdrawals were locked into that schedule; even if he later changed to a different beneficiary who had a longer life expectancy, the withdrawal requirements couldn't be reduced. Factor in the tax owed on the dollars coming out, and many a doctor had to live with this disturbing worry: Am I depleting my nest egg too fast?

The new regulations make the withdrawal process much simpler and financially safer. The slowest withdrawal rate, formerly available only to some people, is now standard for all. What does that mean in dollars? "Say you're 72, with a 70-year-old spouse as beneficiary of your million-dollar plan," says Gary Schatsky, a New York City attorney and financial planner. "Under the old rules, you might have had to take out a minimum of $50,510 every year. Now, your mandatory withdrawal amount is almost 20 percent less—$40,980. The difference stays in your account, growing tax-deferred."

The magic affects estate planning, too. For example, under the old rules, in certain situations heirs might have had to withdraw all of a plan's assets by the end of the year after they inherited them. That stricture is gone. "Now, the worst-case scenario requires heirs to withdraw everything within five years—and new flexibility in the rules makes it easier to prevent that," says David J. Schiller, an attorney in Norristown, PA. "It will just take a little care in planning."

Here are the answers to some questions you may have about how to take advantage of these changes.

What are the key benefits of the new rules?

For starters, they shield your savings by using the most favorable of the three life-expectancy-table options formerly available to most people. This table uses the joint life expectancy of you and a hypothetical beneficiary who's 10 years younger.

That means you'll be pulling money out a lot more slowly. "According to the table, for example, a 70-year-old must withdraw only 3.8 percent," says Noel C. Ice, an attorney in Fort Worth. True, as you get older and life expectancy decreases, required withdrawals grow larger. But even a 90-year-old's minimum withdrawal is just 9.5 percent, Ice says. "So if you have $1 million at age 70 and then earn 8 percent on the balance annually, you'll have $1.5 million still in the account at age 87, after taking out $1.3 million. Under the old rules, with a spouse the same age, your account would total only $740,000 at age 87."

Moreover, almost everyone will now use the same withdrawal calculation—and that will depend on the retiree's age only. "Before, the calculation depended on the ages of the beneficiaries, too, which often made planning complicated," notes Schiller.

Another helpful result: "Now, you can alter your planning to reflect your changing family and financial situation," says Schiller. If one child marries a multimillionaire while another develops money problems, for instance, you can adjust your beneficiary list accordingly.

Only one exception applies—and it works in your favor. If your spouse is more than 10 years younger than you are, you can factor that in and further cut your required distributions.

Should I reconsider my beneficiary choices?

Perhaps, especially if you selected those beneficiaries to maximize your retirement income. "Maybe you would have preferred to name your spouse as beneficiary, but you chose your adult children because their longer life expectancy meant smaller mandatory withdrawals," says New York attorney Gideon Rothschild. "Now, you can choose beneficiaries as you wish, because that choice will have no effect on withdrawals during your lifetime."

If you choose your adult children, chances are you're assuming they'll help your spouse financially, if need be. Keep in mind that you can't be sure what will happen as marriages and remarriages change family dynamics.

What else do the new regulations do?

They facilitate planning after death. No, there's no séance involved; you still must name your potential beneficiaries during your lifetime. However, the ultimate beneficiaries need not be determined until the end of the year following your death.

You may believe estate planning shouldn't leave such loose ends. In fact, Dr. Jones may assume that Mr. Jones should be her plan's sole beneficiary; then he can roll over the account and name a new beneficiary. "But actually, the flexibility of having several possible beneficiaries can be crucial to good estate planning," says Gary Schatsky.

The reason: It's impossible to tell in advance what a family's situation will be, and people don't always update their estate plans as family finances shift. So if you think your heirs will cooperate with each other, you might want to revise your plan so that beneficiaries who don't need the money when you die can disclaim their inheritances in favor of others more likely to need it. That might even save your family a fortune in taxes. "Typically, a well-off widow or widower voluntarily disclaims some of an estate, to let children inherit," says Schatsky. This way, the assets won't be taxable in the adult survivor's estate later.

You might even want to alert your parents to this estate-planning news. They may decide to add you or other adult children as beneficiaries, which may permit one parent to help you by disclaiming a bequest someday.

So protecting my retirement assets is easier now?

To a degree, but don't let your guard down. Despite the new flexibility in adjusting beneficiaries, this area of planning remains riddled with booby-traps. "For a trust to qualify as a plan beneficiary, it still must comply with some very technical rules," says Noel Ice, "and most errors are not correctable after the fact." If a doctor dies before starting withdrawals and leaves a trust with such unfixable errors—say it doesn't meet certain state-law requirements—then his heirs would indeed have to follow the five-year withdrawal schedule.

That's not the only danger zone, Ice warns. "Heirs will also have to withdraw everything within five years if you leave your plan to your estate. You might do that if you get bad advice—or through negligence, simply by failing to name any beneficiary."

How soon must I act?

Given life's uncertainty, the sooner the better. Any important change that affects estate planning—particularly determining beneficiaries—is worth considering immediately.

You should also act right away if you're already older than 70 1/2 and have taken some retirement-plan distributions this year. "You'd be wise to review the situation before taking further withdrawals this year," advises Rothschild, "because your required minimum might be lower under the new rules." Once the money's out, it's out, and you must pay any taxes due.

If you just hit that 70 1/2 mark last year and deferred your first distribution to April 1, 2001, you needn't take action regarding that initial withdrawal; it will be governed by the old rules. However, Rothschild adds, you'll also have to take a distribution for 2001, by this year's end, and you can calculate that distribution the new way.

Also, if someone in your family died during 2000 or 2001, you may want to check the estate-planning aspects of the new rules right away. "Suppose a parent died last year, leaving a plan to a trust that goes 90 percent to you and 10 percent to a charity. Because the trust itself had a beneficiary that wasn't a person, under the former rules that trust wouldn't have qualified as a plan beneficiary," notes CPA Robert Keebler of Green Bay, WI. "So all the plan money would have had to come out within five years."

Under the new rules, however, you can correct that, simply by paying the charity its 10 percent. "Then, as of the end of the year after your parent's death—which is when it counts—you'd be the only beneficiary," says Keebler. "That would entitle you to have the funds paid out using your life expectancy."

Do the new rules apply just to IRAs?

No. Some headlines describe these new rules as IRA regulations, but they apply to all qualified retirement plans, including 401(k)s. Although the new rules are automatic for IRAs, however, you'll need an amendment to make them effective for other plans.

The IRS has issued model language for your plan to use. "This shouldn't be difficult to do," says New York attorney Joshua S. Rubenstein. "But you should certainly take care of it right away."

Moreover, some retirement plans face a hidden distribution danger that has nothing to do with the federal rules, Rubenstein adds. "Many financial institutions that offer plans don't want the ongoing responsibilities of administration. So you may find that their plan language says they'll distribute everything within five years—or even in a lump sum."

What should you do about that? "You can probably roll the whole account into an IRA, but you need to make sure that's done properly and in time, according to all the very specific rules involved," says Rubenstein." Be sure you look into this ahead of time: An institution's mistake can make you liable for additional taxes or even a penalty.

Aren't these just proposed regulations?

Technically, yes, but don't let the word lull you into hesitating. The onerous withdrawal rules we've been operating under since 1987 are also still considered "proposed." The new rules, though not yet dubbed official, still took effect Jan. 1 and will apply to withdrawals for 2001 or later.

Will the IRS relax its enforcement efforts?

On the contrary, notes David Schiller. "It's as though the IRS is saying that since the rules are more flexible, it's more reasonable for us to make sure you follow them," he explains. "So for the first time, they're going to require banks and brokerage houses to calculate and report those mandatory minimum distributions on all IRA accounts." Uncle Sam is going to be watching even more carefully, then.

Indeed, that's the basis of the new rules, says Schatsky. "Besides being a taxpayer's nightmare, those former rules were too complex for the IRS to enforce easily. This simplification helps the public, but it also helps the government's collection process."

And the punishment for rule breakers is harsh, cautions Noel Ice: "The penalty for failing to take the minimum distribution when due is a whopping 50 percent of the difference between what you took and what you should have taken."

 

Brad Burg. Your nest egg just got bigger. Medical Economics 2001;7:67.