THE NEW "IRA-FRIENDLY" IRS

By Edward A. Slott

The IRA rules are so complex that taxpayers and their advisors often fall into tax traps that can lead to substantial taxes on inherited IRAs. But in several recent instances, the IRS has provided relief when IRA owners were unaware of how to make the proper choices.

A Tale of Three Rulings

The following three rulings (all 1999) have a common theme, which is "the IRS is here to help you." In each of these rulings, the IRS assisted taxpayers who were caught in a bind because they did not understand the tax rules.

Life Expectancy and Distribution Method: PLR 199915063

In this case, the IRA owner elected to take his required distributions using the recalculation method and a single life expectancy. This is usually a poor choice, but the IRA owner may not have addressed the consequences of the choices available or may have relied on the advice of the financial institution setting up the IRA. Either way, once he passed his required beginning date, he was stuck. His required distributions could not be changed to the more favorable outcome that results by using a joint life expectancy. Since he had timely named (before his required beginning date) his two children as 50% beneficiaries, the choice of a joint life expectancy would have locked in the age of the oldest beneficiary, both for calculating lifetime withdrawals and post-death required distributions for the two children. A joint life expectancy will always produce a lower required distribution than a single life expectancy. Owners can always withdraw more than the required amount, but they cannot take less without incurring a 50% penalty on the shortfall. Therefore, there is no reason to use a single life expectancy.

If this IRA owner had elected to use a joint life expectancy, the annual lifetime required distributions would have been determined based upon his age and the age of the oldest of the two beneficiaries. Since the beneficiaries here were nonspouses 10 or more years younger than the IRA owner, the MDIB table (the 10-year table) would have been used to calculate the joint life expectancy. Even so, the MDIB factor still would have produced a lower required withdrawal than using a single life factor.

The other mistake was electing to use the recalculation method instead of the term certain method. Under the recalculation method, the IRA owner's life expectancy drops to zero in the year after his death. The two children/beneficiaries would have to withdraw the entire IRA balance in the year after death, incurring a huge income tax and a complete loss of any further tax deferral on the IRA fund. Consequently, the IRA would no longer exist.

This IRA owner died at 74 years of age on July 11, 1997, and his beneficiaries were now faced with a 100% IRA distribution by December 31, 1998, the year after their father's death.

The beneficiaries sought a ruling from the IRS to determine whether their father's error could somehow be rectified. The new IRA-friendly IRS responded favorably, allowing the two children to continue required distributions over the oldest child's remaining term certain life expectancy. The two beneficiaries were ages 40 and 37 in 1993, the year the IRA owner attained the age of 70 Qw . The term certain life expectancy for the oldest beneficiary was 42.5 years. At her father's death five years later, without recalculation, her life expectancy would be 37.5 years. The beneficiaries' 1998 required distribution will be calculated based on this life expectancy, 1/37.5 or 2.67%.

The key here was that the beneficiaries were properly named before the required beginning date. Since a nonspouse beneficiary cannot recalculate, the IRS allowed the term certain method to be used for the beneficiaries after the death of the IRA owner.

Where's the Authority for This Position?

Here is the chapter and verse directly from the IRS ruling:

We conclude that Grantor's [the IRA owner's] use of the single recalculated life expectancy in determining the required minimum distributions during his lifetime does not preclude the use of the term-certain life expectancy of the oldest designated beneficiary in the calendar year after Grantor's death.

The IRS's reasoning for this position is explained as follows:

Although his [the IRA owner's] benefit was paid in the form of a single life expectancy upon his death, his life expectancy was not the last applicable life expectancy because he timely designated his beneficiaries by his required beginning date. Therefore ... for purposes of determining the minimum distribution in the calendar year after the death of the Grantor, the applicable life expectancy is the life expectancy of the designated beneficiary.

This ruling will save many beneficiaries from otherwise being forced to distribute the entire IRA within the year following the year of the IRA owner's death, due to poor advice (or no advice). As a case in point, Paul Knott, a financial consultant with Salomon Smith Barney in Wilmington, North Carolina, brought this to his client's attention and was able to use this ruling to save his client, a nonspouse IRA beneficiary, from being forced to distribute a $425,000 IRA in the year after her mother's death. This would have easily resulted in a tax of over $150,000 and ended the tax deferral on the inherited IRA forever. Instead, his client can now use her remaining term certain life expectancy of 32.2 years. The growth on an IRA of $425,000 at a return of 9%, taking into account the required distributions, would be $2,565,265. That's a powerful difference.

Note: Some IRA beneficiaries will not be able to take advantage of this ruling if the plan itself forces a lump sum distribution.

Separate Shares for Beneficiaries: PLR 199903050

An August 1999 ruling (PLR 199931048) addresses the IRS regulations where there are multiple beneficiaries (co-beneficiaries) named on a single IRA account. As discussed earlier, the age of the oldest beneficiary (with the shortest life expectancy) is used to calculate required distributions.

A problem arises when there is a large difference in ages between the oldest and youngest beneficiaries. Many IRA owners were not aware of this potential tax trap and named multiple beneficiaries on a single IRA. Many advisors recommend splitting IRAs and naming different beneficiaries, utilizing each life expectancy.

This is not a problem when the IRA beneficiaries are close in age. For example, naming two grandchildren who are ages 8 and 6 will not make much of a difference. But if you named your spouse along with your 6-year-old grandchild as co-beneficiaries on the same IRA, the 6-year-old will lose out on a 75.6-year life expectancy. The situation is even worse for those who name a charity along with a person as co-beneficiary on the same IRA. Since a charity is not a designated beneficiary (it is not a person), it has a zero life expectancy. Any beneficiary named along with the charity would be forced to use a zero life expectancy, resulting in a speedy confiscation of the IRA.

In a little-publicized ruling (PLR 199903050) where the IRA owner died before his required beginning date, the IRS indirectly addressed this issue with an adverse ruling. The IRS's reason for disallowing the taxpayer's request is now the basis of a favorable solution to the above problem. The IRS's current position (based on this ruling and the August one) is that where multiple beneficiaries are named on a single IRA, the co-beneficiaries will be allowed to each use their own life expectancy. This will only hold if the IRA owner dies before his required beginning date and the IRA beneficiary designation form clearly creates the separate shares.

The IRS's position on what qualifies as a clearly indicated separate share is a fraction (e.g., Qe each) or a percentage. This would enable the co-beneficiaries to use their own life expectancies without having to use the age of the oldest, but only if the IRA owner dies before his required beginning date.

Many advisors still recommend splitting IRAs when the amounts and beneficiaries' age differences are significant. You may still find yourself being forced to use the age of the oldest if you misinterpret these rulings, thinking they will still provide tax relief when the IRA owner reaches his required beginning date.

A Tax-Friendly Trend

Once again, the IRS has demonstrated a taxpayer-friendly position and helped taxpayers out of potentially costly predicaments. I believe this is a trend that will continue as long as there are so many people being blindsided by incomprehensible tax rules, especially in the IRA area. This may be the IRS's way of asking Congress for simplicity. Can there be such a thing as easy-to-understand IRA rules? I'm counting on Congress to preserve my livelihood for many more years. *

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